Earlier this week, the Bank of England produced their regular money supply data. It showed that despite the credit crunch, the UK is still creating huge amounts of liquidity. In the year up to June, the money supply increased by 11.5 percent.
There is one principle that showed never be forgotten; inflation is always and everywhere a monetary phenomenon. In this form, the principle was coined by Milton Friedman. However, even the Romans and Greeks understood it. Emperors and city-states knew that reducing the amount of precious metal in new coins invariably lead to increasing prices.
It is no different today. During the last couple of years, the UK has seen extraordinary monetary growth, and as sure as night follows day, we are seeing inflation pick up and accelerate.
Yet, there are still some who think that the disruption in world financial markets will lead to a sudden collapse and uncontrollable collapse of monetary aggregates, leading to a 1930s debt deflation. Well, it hasn't happened yet.
The Bank of England has several measures of the money supply. M4 is perhaps the most popular measure. Basically, M4 covers notes and coins, current accounts and savings deposits that can be quickly converted into spendable cash.
Since M4 measures money, it follows that someone has to be actually holding this cash. The Bank of England conveniently breaks this data down into three groups; households, non-financial corporations, and other financial corporations. So what has been happening to the money holdings of these three groups.
The deflationist case rests on the smallest component of the money supply; non-financial corporations (NFCs) holdings of M4. It is true that the growth rate has slowed considerably over the last 12 months. A closer examination of the data suggests that NFC holdings have been quite erratic. It has fallen sharply during the most turbulent months of the credit crunch. When things quieten down, the growth rate resumes. In fact, more recently, NFC holdings of money has begun to grow again.
Now lets look at my favourite measure of money - household holdings of M4. Since inflation is essentially a process where there is too much money is chasing too few goods, household holdings of money is a very good guide to inflationary pressures. It has been growing at around 8-10 percent a year. In fact, in the last couple of months, the rate has picked up slightly.
The final component of the money supply is the most mysterious; holdings of other financial institutions. This category has grown at a shocking rate in the last 3-4 years, sometimes at around 30 percent a year. Although the growth rate has dropped slightly, it is still increasing at an extremely rapid rate.
What are other financial institutions? They are non-deposit-taking bank-like institutions. They have become increasingly important as banks have tried to evade regulatory capital requirements and move their lending activities off-balance sheet. This OFIs hold large deposits in regular banks. However, the counterpart to these deposits are found on the balance sheets of OFIs as lending. Make no mistake, the M4 holdings of OFIs is real money. Somewhere in the economy it creates demand, leading to the familiar problem of "too much money chasing too few goods".
So, the data is fairly clear. The money supply continues to grow at a inflationary rate. The decline of M4 holdings by NFCs suggests that firms might be a little short of cash, however households continue to have large amounts of it, and this wil cause inflation.
When the data suggests otherwise, and money supply growth starts to decline, I will think otherwise. Despite the credit crunch, which is for the most part a housing market credit crunch, the data screams inflation. Only higher interest rates will prevent it from rising further.