UK prices hit an M4 roadblock

In the UK, the M4 is a highway that joins London and Wales. It is also a measure of broad money supply.

Our Quantity Theory of Money (hyperlink) article pointed out the relationship between money stock (or supply) and the prices of goods and services in an economy. The relationship can be patchy but, in general, more money in an economy equals higher prices and less money equals lower prices.

The UK M4 statistics for June, released on 31 July, showed a 0.2% month-on-month drop which followed a drop of 0.1% the previous month. In year-on-year terms, M4 growth slowed to 5.3%, down from a high of 8.2% in April. The large contraction in M4 is mainly due to drops in wholesale deposits that the private sector has with financial institutions – perhaps an early warning of a dash for cash developing.

UK M4 Money Supply YoY 1

But it is the relationship between M4 and the UK Retail Price Index (RPI) which is illuminating. The RPI is the UK’s measure of increasing and decreasing prices (what just about everybody wrongly refers to as inflation and deflation), and it has been increasing in the last couple of years, up from 0.7% year-on-year in October 2015 to 3.5% in June 2017. Most people refer to this increase in prices as “reflation”. This is wrong. Prices do not inflate or deflate – they increase and decrease. It is the supply of money and credit in an economy that inflates and deflates.

As our chart below clearly shows, the increase in RPI which started in October 2015 occurred only after the deflation of M4 had bottomed out and M4 was recovering (deflating at a slower rate) from February 2015.

In fact, if we exclude the Global Financial Crisis (GFC) period – admittedly not ideal but it was an extraordinary couple of years in monetary economics – we can see that there is a fairly strong positive correlation between M4 money supply and RPI. Disinflation (inflating at a slower rate) in M4 led a slowdown in RPI growth in the early 1990s, at the end of the 1990s and notice how M4’s disinflation accelerated in the first half of 2008 before the GFC tornado hit the ground.

We now wonder whether the big drop in M4 growth in recent months will lead a drop in UK retail prices. That would cause a re-evaluation by the Bank of England who are currently erring on the hawkish side.

Funnily enough, the M4 highway ends in Wales about a kilometer away from Ebenezer Road. Like Charles Dickens’ famous character Ebenezer Scrooge, the M4 money supply could be warning of frugal times ahead in the UK.