Expert Commentary

Deflation in the U.K. On the Horizon

The Bank of England is concerned about consumer price inflation. But deflation might be more likely.

Mention M3 in the U.K. and most people will think of the motorway that travels from south-west London and meanders through England’s green and pleasant land to Southampton. But to financial market participants, M3 is an important indicator of the economy being, as it is, a measurement of money supply. The message it is sending at this juncture is noteworthy.

Yesterday, the Bank of England laid out its concerns about a sustained acceleration in consumer price inflation and talked tough about its willingness to tighten monetary policy were that to happen. Yet, the chart below shows that monetary policy is already being tightened.

The growth rate of M3 money supply has been slowing very sharply over the past few months. For those who believe in the quantity theory of money, such disinflation in money supply will mean that the growth rate in consumer prices will also start to slow. As we have mentioned before, and as you can see from the chart, the relationship between money supply and consumer prices is not all that monetarist economists would have us believe. Indeed, the correlation coefficient between the M3 money supply growth rate and that of consumer prices since 1988 is a measly 0.29 – no relationship at all.

Nevertheless, on some occasions in the past (highlighted), decelerating money supply growth has preceded a slowing down in consumer price growth. The jury is still out on whether that will happen again this time but, if it does not, the Bank of England appears willing to allow money supply growth to turn negative. In other words: deflation.


UK Money Supply and Consumer Prices- August 2021