Money and financial markets
the amount of money and credit
financial market interest rates
the exchange rate
other asset prices
the amount of money and credit 
An old song has it that 'money makes the world go round'. It certainly turns the wheels of the economy and it is central to thinking about inflation. As the Inflation section explained, inflation represents the rate of decline in the value of money. Without money, there would be no inflation.
As we explained in the Policy Framework section, the UK authorities no longer attempt to target the growth in the money supply as a means of controlling inflation. But the money supply does play an important role in the transmission mechanism and as an indicator of economic conditions. And, ultimately, the control of inflation implies the control of monetary growth. The box below discusses this.
money and inflation
The amount of money in the economy and the level of prices are positively related in the long run. Without money, inflation could not exist. And, across many countries, persistently high rates of money growth have usually been associated with high inflation.
Excess demand is likely to be accompanied by strong growth in the amount of
money deposited in banks and building societies, and the amount of lending
undertaken by banks and building societies. Consider, for example, what happens
if the official Bank Rate is reduced. Banks are likely to reduce the interest
rates they charge on their loans to individuals and businesses. In addition
to boosting spending directly, this is also likely to lead to increased demand
for loans which, if met, will increase the amount of money in bank deposits.
So a change in the official Bank Rate is likely to result in a change in
both bank deposits and bank lending.
Although money and inflation are clearly linked over the longer term, the usefulness of money as an indicator of inflationary pressures in the short to medium term depends on there being a predictable relationship between money and the value of spending. For example, suppose money grew at the same rate as the value of spending over time. Then money growth of 4.0%-4.5% per year would be consistent with annual growth in economic activity of 2%-2.5% - the historical average in the UK - plus inflation of 2.0% per year, in line with the inflation target.
In practice, however, the relationship between money and inflation has not been stable. Money growth has been influenced by many other factors, including financial innovations - such as the introduction of credit cards - changes in banking regulations, and developments in international capital markets. The effects of these changes have not always been easy to predict accurately. So rules of thumb like the one above have not usually been useful guides for policy.
Nonetheless, data on bank deposits, bank lending and cash are helpful in providing indications about both current and future spending in the economy. They can corroborate other data or sometimes give leading indications of spending behaviour since the figures are released earlier than GDP data. In particular, data on deposits and lending to households and companies can provide useful clues about consumer spending and company investment.
narrow money - notes and coin
Notes and coin in circulation in the economy are referred
to as 'narrow money'. Growth in the amount of notes and coin
in the economy provides one indication of how much household
spending might be rising. That is because notes and coin are
still an important means of payment, despite the growth in
the use of debit and credit cards. If people withdraw notes
from cash machines, they are likely to use them for spending
in the near future.
An increase in notes and coin in circulation in a particular
month might signal a rise in the value of retail sales. Data
for notes and coin are released ahead of retail sales data.
Note that we have said the value of retail sales, not
the volume. Money will reflect the value of expenditure, ie
the price and the volume. It is a nominal variable, in the
way we explained in the Using
Statistics section.
broad money - money in bank and building society accounts
Notes and coin only represent a small part of what we call
'money'. Money in a wider sense largely consists of what is
held in bank and building society accounts. 'Broad money' is
the term used to describe the amount of money held in these
accounts plus notes and coin in circulation.
The measure of money that captures this definition is called M4. As well as aggregate M4, data are also available for the money held by different sectors of the economy - households, companies and financial institutions other than banks.
Alongside the amount of money deposited, there are also data for the amount of lending undertaken by banks and building societies. Again, these are available for the economy as a whole - known as M4 lending - and for individual sectors. In particular, there are data covering lending to households. These are divided into secured lending, ie lending backed by assets such as housing, and unsecured lending, such as credit card debt. Loans secured on housing represent around 80% of personal debt.
We can look at the growth of bank deposits and lending both for the whole economy and for different sectors, to see if they provide any indications about future demand.
households
Household spending power is likely to be related to the size of individuals' bank and building society accounts. Higher growth in household deposits might reflect an increase in savings. But it could also signal a future rise in consumer spending growth.
On the borrowing side, households can borrow from banks and building societies to supplement their income in order to help finance spending or to buy a house. Data on household borrowing can provide information about current and future consumer spending.
private non-financial corporations (PNFCs)
Companies' deposits and borrowing data can provide similar insights into their investment behaviour. For example, companies may build up bank deposits or increase borrowing to finance investment in new equipment and buildings.
other financial corporations (OFCs)
Financial institutions other than banks and building societies - such as life assurance and pension funds - also have bank deposits. The deposits of OFCs may rise or fall in response to their financial market activities - for example, financial institutions might switch to holding money rather than other assets in order to carry out financial transactions such as purchasing company shares. Such changes might influence asset prices, but often they may have little to do with future spending and investment in the wider economy. Whatever the reason, because the behaviour of financial institutions can cause large movements in the aggregate measure of M4, it is necessary to monitor the data for OFCs before drawing conclusions about the significance of the growth in broad money more generally.
credit conditions
In addition to providing indications about future spending and investment, monetary data can also be used to assess conditions in the banking sector. There may be circumstances in which the banking sector reduces or increases the amount of lending it undertakes. For example, losses on bad loans either in the UK or overseas might restrict banks' abilities to lend. This is sometimes referred to as a 'credit crunch'. In turn, this may reduce spending and investment and lead to lower inflation. The opposite is a 'credit boom', which might result in an increase in spending and investment, and lead to higher inflation. Deregulation of financial markets in the 1980s led to a big increase in the amount of credit available.
Key data: money and credit
notes & coin
M4
M4 lending
consumer credit
financial market interest rates
Interest rates - the cost of borrowing - are important determinants
of both the demand for, and the availability of money and credit.
By examining interest rates on savings, such as deposit account
rates, and the cost of borrowing, such as mortgage rates, you
can better understand how official Bank Rate decisions made
by the MPC might be affecting spending and saving behaviour
in the economy.
Market interest rates may not change immediately or by the
same amount as changes in the official Bank Rate. At any point
in time, other factors might be influencing interest rates.
For example, increased competition amongst financial institutions
might result in lower mortgage or credit card interest rates.
The speed and extent of the pass-through from official Bank Rates to market rates will affect the impact of MPC policy
decisions.
The amount by which some market interest rates change following
a change in the official Bank Rate will also depend on
the extent to which a policy change is anticipated by financial
markets, and how the change affects market expectations of
future policy. If a change in the official Bank Rate is expected,
market interest rates might change beforehand. It is possible
to observe interest rate expectations by looking at different
financial market prices. Newspaper articles about MPC interest
rate decisions usually refer to what financial markets expect
to happen, and the MPC discusses market expectations at its
meetings.
the official Bank Rate
The MPC sets the interest rate at which financial institutions, such as banks and building societies, can borrow money from the Bank of England. The specific interest rate set by the MPC is a rate for borrowing for a two-week period. It is known as the official Bank Rate.
short-term interest rates
When the official Bank Rate changes, this is quickly transmitted
to other short-term interest rates in the money markets - such
as the rates charged by banks when they lend to other banks.
Short-term market interest rates are important as they tell
us about the cost to financial institutions of obtaining funds
that can then be used to provide loans to customers such as
mortgages and overdrafts.
An alternative source of funds for banks is savings deposits
placed with them by customers. The rate on these deposits will
typically move with the official Bank Rate set by the MPC.
So movements in the official Bank Rate set by the MPC are important
for both savers and borrowers.
long-term interest rates
Households and firms in the economy often want to borrow money for long periods of time. One way to borrow in this way is to take out a sequence of short-term loans at short-term interest rates. Alternatively, borrowers might want to fix the cost of borrowing in advance. Fixed borrowing rates for long-term loans are called long-term interest rates.
These interest rates matter most to individuals taking out fixed-rate mortgages or firms looking to raise long-term finance for investment. One way of observing changes in long-term market interest rates is to look at the returns - or 'yields' - offered on government and corporate bonds which extend over long time periods - for example five, ten or fifteen years.
changes in long rates
Long-term interest rates tell us about financial market expectations of future inflation and interest rates. As such, they provide an indication of the credibility of monetary policy, ie the extent to which financial markets believe that the MPC will achieve its target.
In practice, short and long-term interest rates are likely to be closely related, with long-term rates being an average of expected short-term rates over the period of the loan. So if the MPC is expected to raise short-term interest rates in the future, the current rate for long-term borrowing might be higher than the current short-term rate to reflect the expected higher future cost of funds. And if short-term rates are expected to fall in the future, long-term interest rates might be lower than short-term rates.
This means that, while short-term rates largely depend on the MPC's interest
rate decisions, long-term interest rates also depend on market expectations
of economic developments and monetary policy in the future. So long-term interest
rates can and do vary without any change in the current official Bank Rate
set by the MPC, as financial markets continuously revise their expectations
about future official Bank Rates and other variables, including inflation.
A rise in the official Bank Rate could generate an expectation of lower future
interest rates, in which case long-term rates might fall.
Although a change in the official Bank Rate almost always moves other short-term
interest rates in the same direction - even if some are slow to adjust - the
impact on long-term rates can go either way.
Key data: interest rates
Bank of England Bank Rate
money market rates (short rates)
bond yields (long rates)
the exchange rate
Exchange rates are particularly important financial prices. They measure the price of one country's money in terms of another. Consequently, they depend on factors both at home and abroad, including domestic and foreign interest rates. Changes in interest rates in the UK may affect the exchange rate between sterling and, say, the euro. But so may changes in interest rates set by the European Central Bank. It is important to bear in mind, however, that interest rates are not the only influence on exchange rates. They will also reflect the demand for, and supply of, goods and servcies, and any other factors affecting international transactions in goods, services or assets. The rise in the value of the pound after mid-1996, particularly against the euro, appears to have been driven to a significant extent by factors other than UK and overseas interest rates.
Although monetary policy does not aim to achieve a particular level for the exchange rate, it has to take into account how changes in the exchange rate impact on inflation prospects. In the Inflation Outlook section, we explained that a change in the value of sterling can have a direct influence on inflation through changes in import prices, and an indirect effect through its impact on demand for exports and imports. But the nature and size of these effects will depend on the reasons for a change in the exchange rate.
For example, an appreciation of sterling might reflect an increase in demand for UK goods and services. So rather than a higher exchange rate reducing demand for UK goods, it might be a reflection of rising demand. It is, of course, often difficult to know what has caused the exchange rate to change. But it is important not to view changes in exchange rates and interest rates in terms of a simple mechanical relationship. Some of the possible effects on import prices and the composition of demand are discussed in the box below.
bilateral and effective exchange rates
You can look at the pound's exchange rate on what is termed a 'bilateral' basis - the exchange rate between two currencies, such as the pound relative to the US dollar - and what is termed an 'effective' basis.
An effective exchange rate is an average of different bilateral
exchange rates, weighted according to the importance of each
one to a country's trade. The sterling effective exchange rate
index (ERI) reflects the pattern of UK trade with its 29 main
trading partners. The sterling-euro exchange rate has a weight
of 55% in the ERI.
You can also look at other exchange rates to shed light on movements in sterling. For example, you can see if a change in the rate between the pound and the euro has been similar to the exchange rate movements between the dollar and the euro. This might help to explain what has caused exchange rate changes. Other exchange rates also help us to assess future economic conditions in the UK's main trading partners.
the exchange rate and import prices
Import prices are an important component of many firms' costs and of final consumer prices. An appreciation of sterling - a rise in its value relative to other currencies - will tend to lower the prices of imported goods and services, and a depreciation will tend to increase them. The effects may take many months to work their way through the supply chain and into consumer prices. Import prices are discussed under 'Costs and prices'.
the exchange rate and demand
Depending on the reasons for a change in the exchange rate and whether it is sustained, a lower exchange rate will tend to make foreign goods more expensive relative to goods produced at home. This can affect the composition of total demand in the economy, which could have implications for output growth and inflation. A fall in the relative prices of UK output might encourage a switch of spending towards home-produced goods and services away from those produced overseas. For any level of overall demand, domestic production will be higher and imports lower. This may therefore increase inflationary pressure relative to what it would otherwise have been.
The exchange rate has its biggest impact on the manufacturing
sector, which accounts for around 55% of UK exports. But other
sectors, such as agriculture and service industries like tourism
and consultancy, are also affected - for example, foreign holidays
can become more expensive and UK holidays relatively cheaper
if the pound falls in value. Exports and imports are considered
under 'Demand and output'.
other asset prices
Asset prices - such as share prices and house prices - can also provide information about future developments in economic activity and inflation. Rising house prices might reflect how confident consumers are feeling about the future. Falling house prices might indicate the opposite. The housing market is discussed under 'Demand and Output'. Share prices will reflect investors' expectations of companies' future profits. In this way, they can provide a useful barometer of expectations and confidence in future economic developments. You can monitor UK share prices by looking at the Financial Times Stock Exchange (FTSE) indices.
Key data: asset prices
£/$ exchange rate
£/€ exchange rate
$/€ exchange rate
sterling ERI
FTSE all-share index
FTSE 100 index
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