The Bank of England’s latest Monetary Policy Report has finally embraced what monetarist economists have long demanded: the inclusion of ‘money’, specifically broad money, or M4x in economic jargon, which covers all private sector bank deposits. This measure offers a comprehensive snapshot of the money available in the economy for spending and investment. One might think its inclusion is innocuous, yet it marks a significant shift away from the interest rate-centric approach that has dominated economic policy, particularly within the Monetary Policy Committee, since the adoption of the New Keynesian model.

Despite the long-standing reliance on interest rates to manage economic cycles, this approach has often proved inadequate in preventing economic instability, as evidenced by the recurring boom-bust cycles. Such volatility highlights the need for a more comprehensive and nuanced monetary policy that acknowledges the complex interactions between changes in broad money, asset prices, and economic stability.

For nearly three decades, manipulating interest rates has been the principal tool for influencing economic activity and aggregate demand. The conventional wisdom suggests that lowering rates stimulates borrowing and investment, ostensibly leading to economic growth, while raising rates is intended to curb inflation and cool an overheated economy. However, this view oversimplifies the dynamics at play and overlooks the significant impact that fluctuations in broad money can have on asset prices, national income, and inflation.

In reality, broad money is a fundamental driver of economic activity. Variations in the amount of broad money can lead to significant changes in asset prices, which in turn influence economic output and the overall price level. Excess money typically flows into investments in equities, property, and bonds, driving up their prices and generating wealth effects that further stimulate economic activity and inflationary pressures. Conversely, when the supply of broad money contracts, it reduces demand for assets, depresses prices, and can trigger economic downturns. Recognising and managing these cycles is essential for maintaining economic and price stability.

The UK’s economic history offers instructive lessons in this regard. In the early 1970s and late 1980s, the UK witnessed pronounced boom-bust cycles driven by fluctuations in the broad money supply. The Heath-Barber boom of the early 1970s and the Lawson boom of the late 1980s were both characterised by rapid increases in broad money, which fuelled asset price bubbles. These were followed by severe busts when the money supply subsequently tightened.

For instance, from 1971 to 1973, the annual growth rate of broad money was approximately 25%, far exceeding the rates associated with price stability. This expansion resulted in skyrocketing inflation, which peaked at nearly 25% in 1975, followed by a severe recession as money supply growth decelerated. Similarly, from 1986 to 1989, financial deregulation and innovation under Lawson led to an annual broad money growth rate of about 15%. This monetary surge significantly inflated house prices and nearly doubled the FTSE 100 share index. However, subsequent monetary tightening to combat inflation, which peaked at 9.5% in 1990, led to a sharp correction in asset prices and a severe recession.

The COVID-19 pandemic presented a similar scenario. In response, the UK government and the Bank of England implemented unprecedented fiscal and monetary measures, including substantial unconventional monetary policy through Quantitative Easing (QE). The Bank nearly doubled its existing QE programme, expanding asset purchases by £450 billion from March 2020 to December 2020. This intervention led to a significant increase in the annual rate of broad money growth, which peaked at 15.4% in the year to February 2021.

This massive monetary injection saw the FTSE 100, which had plummeted to around 5,000 points in March 2020, rebound robustly to 7,400 in 2022 and continue to 8,500 points in 2024. UK property prices also rose sharply, with average prices at a national level increasing by 20.4% between January 2020 and December 2022. In Wales, the figure was even higher at 29.3%. However, this rapid expansion in the money supply also fuelled inflation, with the annual rate climbing to a 40-year high of 11.1% by October 2022.

Experiences in Japan and the United States further underscore the pivotal role of broad money in economic stability. Japan’s economic landscape in the 1980s offers a stark example of the effects of unchecked money supply growth. From 1986 to 1990, Japan’s broad money expanded at an average annual rate of 10%, fuelling substantial increases in asset prices. The Nikkei 225 surged from around 13,000 points at the start of 1986 to nearly 40,000 at the beginning of 1990, while Tokyo land values rose 10.4% in 1986, 57.5% in 1987, and 22.6% in 1988, more than doubling in just three years. However, subsequent monetary tightening by the Bank of Japan led to a dramatic reversal: asset prices plummeted, land prices fell by more than 50% in three years, and the Nikkei 225 lost half its value by October 1990. This resulted in a prolonged economic malaise known as the “Lost Decade”. During this period, Japan’s real GDP growth dwindled to an average of just 1.2% per year, markedly below the previous decade’s rates.

Similarly, during the Great Depression (1929-1933), the United States experienced a catastrophic collapse in the broad money supply by about one-third, which precipitated a steep decline in asset prices and triggered widespread bank failures and a severe decline in economic activity and deflation. This period vividly illustrated the severe consequences of rapid decreases in money supply, meticulously documented by Milton Friedman and Anna Schwartz in their seminal work, “A Monetary History of the United States, 1867–1960”. Both historical and contemporary examples underscore the critical role of broad money in economic stability and highlight the limitations of traditional monetary policy approaches that focus primarily on interest rates.

In conclusion, managing modern economies effectively necessitates a comprehensive strategy that includes vigilant monitoring of broad money supply alongside interest rate adjustments. This approach would help stabilise asset prices and harmonise monetary and fiscal policy efforts, ensuring a more resilient economic environment and mitigating boom-bust cycles. As we navigate the complexities of the post-pandemic economic landscape, rethinking our monetary policy frameworks is essential for deepening our understanding of economic cycles and achieving long-term economic stability and growth. While the inclusion of broad money in the Monetary Policy Report is a step in the right direction, policymakers must now break free from their overreliance on conventional economic orthodoxy and place greater emphasis on what the monetary aggregate data is indicating.

 

Damian Pudner is the Director of the Institute of International Monetary Research.