M4 growth has been volatile over the last decade. Growth was exceptionally strong in the middle of the 1990s and again in the period 2004 to 2008. For most of the 1990s and the 2000s, growth in the money supply outpaced nominal GDP growth.

Further analysis, however, shows that much of the excess growth, at least until the late 1990s and from 2004 onwards can be attributed to developments in the other financial corporations (OFCs) sector.

Other financial corporations consist of private financial corporations other than monetary financial institutions (see 9.4 Measures of Money - Broad Money) and include institutions such as insurance companies, pension funds and companies involved in fund management.

This sector experienced strong balance sheet growth for much of the 1990s and in the 2000s which was accompanied by a desire to hold higher money balances.

Excluding the build up of OFC deposits from M4, i.e. focussing exclusively on individuals and non financial companies, shows M4 growth to have been roughly in line with nominal GDP growth and the velocity of circulation to have been stable up until 1998.

Thereafter, growth in non-financial company and personal sector deposit holdings accelerated away from GDP growth until the end of 2007 when the rate of growth decelerated sharply (see Chart 9.4 below).

Within the overall figure, household deposit growth was robust for much of the 2000s, growing by over 8% a year between 2001 and the middle of 2008 before slowing to an annual rate of 3% by mid 2009.

Company sector deposit growth had begun to decelerate six months earlier and through much of 2008 to the middle of 2009, companies reduced their deposit holdings with banks.

The difficulty of interpreting money supply trends is underlined by comments made in the May 2001 Inflation Report which suggests that such “strong growth rates of broad money could indicate robust future spending growth”.

On the other hand, the report also notes that households could have increased their holdings of deposits for other reasons. This might have been to rebalance portfolios after earlier increases in equity prices, as a precaution because of worries about the state of the economy or because of worries that share prices could be due for a fall.

With the benefit of hindsight, the fact that “the strong growth rates of broad money” has continued unabated at least until 2007-08 and that spending growth has also been robust, suggest that the initial thought was the correct one.

It is also worth noting, however, that there has been no discernible effect on inflation from this robust growth emphasising the fact that, short term, at least, the relationship between money supply movements and inflation often breaks down.

In addition to analysing M4 deposit growth, the Bank of England also looks at trends in lending by banks and building societies, both in total and to individual sectors. The Bank of England will be interested in examining these trends to gain clues about what is happening in the UK economy. Such information may provide support for other current demand indicators or it may provide an early warning of future demand trends.

Overall, lending to the UK private sector grew strongly from the early 1990s up until the first half of 2008, both to individuals and non-financial companies (see Chart 9.5 below).

In analysing data on lending to individuals, the Bank of England will be interested in two key areas:

• the strength of secured lending (largely mortgages) and its effect on the housing market
• the strength of unsecured lending (consumer credit through credit cards, personal loans and overdrafts) which will directly influence consumer spending.

Concerns due to increase in housing wealth

The Bank’s worry about the effect of strong housing activity is that it indirectly affects consumer spending through two routes (see The Housing Market 14.1 Significance of Housing ).

• Firstly, increases in house values boost consumer confidence and therefore spending. The increase in housing wealth is seen as an increase in savings. The result is that consumers then feel free to spend a greater proportion and save a smaller proportion of their income.
• The second route is where the increase in housing wealth tempts consumers to borrow more to finance increased consumption. This may be via consumer credit (unsecured debt) or it may be through what economists call mortgage equity withdrawal (MEW).

MEW is simply individuals increasing the amount of debt secured on property by more than they need simply to finance house purchase or home improvement.

The extra money may be used directly to boost consumer spending. It might equally well be used to increase saving, of course, but when consumer confidence is high the former is the more likely outcome.

Lending to individuals was consistently strong for much of the 2000s, both in secured and in unsecured lending (consumer credit through credit cards, personal loans and overdrafts).

Secured and unsecured borrowing by individuals was encouraged by a high degree of consumer confidence, nurtured by an extended period of consistent and stable economic growth, an accompanying sustained fall in unemployment and a significant relaxation in monetary policy.

Reaction by the Bank

The Bank reduced interest rates seven times in 2001 taking base rates down from 6% to 4% at which rate they stayed through 2002, before being reduced to 3.5% by the summer of 2003.

At the same time, competition among financial institutions led to a squeezing of mortgage rates which further encouraged borrowing.

Buoyant consumer confidence, falling interest rates and the sharp increase in housing wealth brought about by strong house price rises, especially in the south of England, also led to a return to mortgage equity withdrawal (see Chart 14.4 Consumer Borrowing).

The strength of this reaction was such that at its peak, this form of borrowing was equivalent to over 8% of disposable incomes, substantially adding to potential spending power.

It therefore raised significant concerns for the monetary authorities. The last time that MEW had been high was during the late 1980s boom when consumer spending growth became unsustainable.

Since the end of 1999, borrowing by private non-financial companies from banks and building societies has generally been strong.

For much of the period, these companies have also raised substantial amounts on the UK capital markets, either through the issue of extra shares or through bond issues.

In total, companies raised far more money in 2000 than was necessary to meet the difference between internally generated funds (the amount left over from profits after dividends have been paid) and the cost of investment they undertook.

This ‘extra’ funding was largely used for two things. A large slice can be attributed to borrowing by a small number of companies to acquire mobile telecommunications licences while much of the remainder was used to finance the acquisition of other companies, both UK owned and overseas owned.

A similar picture was seen in 2004 and the first quarter of 2005. In this period internally generated funds were more than sufficient to meet corporate spending on new capital equipment or expansion of existing operations, yet companies’ borrowing from banks remained robust.

Instead, companies used their net saving (internally generated funds less capital expenditure) plus externally raised funds such as bank borrowing to buy back their own shares (the value of share buyback doubled), to finance mergers and acquisitions and to build up liquid assets (bank deposits).

By the middle of 2006, the economy was deemed to be growing too fast and monetary policy was gradually tightened.

Between August 2006 and July 2007, Bank Rate went up a full percentage point to 5.75%, putting pressure on a heavily indebted personal sector which had to cope with servicing a debt level which had hit £1.5 trillion, equivalent to 160% of personal incomes. Further borrowing and spending came under pressure.

As a result, the housing bubble burst and consumer confidence evaporated while in the corporate sector weakening activity led to firms deciding to cut back on business investment.

With only the public sector making a positive contribution, GDP growth slipped well into negative territory in the middle of 2008.

Interest rates were eased in late 2007 and early 2008 but only as far as 5% since the MPC was still worried about inflationary pressures in the economy. Indeed it was not until the autumn that concerns about deflation ousted inflationary worries and Bank Rate was slashed.

In a situation where the credit crunch had exacerbated the downturn, the traditional form of monetary loosening proved inadequate, however, and in March 2009, quantitative easing was introduced to kick start the economy.