The key chart
Growth trends (% YoY) in narrow money (M1) and other short term deposits (M2-M1) (Source: ECB; CMMP)
The key message
Recent events have bought renewed attention to monetary developments in the euro area (EA). One component of money supply captures the attention – narrow money or M1. The reasons are simple:
- Growth in M1 is slowing at its fastest annual rate since the creation on the EMU
- Real growth rates in M1 typically display leading indicator properties with real GDP
M1 dynamics make great headlines for sure, but they only tell one part of the current EA macro and banking story.
The rising opportunity cost of holding money, on-going portfolio rebalancing and the mechanics of money creation are important too. Together they provide critical context for understanding current EA monetary and macro developments fully:
- Opportunity cost: unprecedented ECB tightening has increased the opportunity cost of holding money and triggered a partial re-allocation of ON deposits to better-remunerated, other ST deposits (see key chart above)
- Portfolio rebalancing: the phasing out of net asset purchases and TLTROs has incentivised bond issuance and encouraged portfolio rebalancing away from deposits to LT bank liabilities, (note, the latter do not form part of monetary aggregates by definition)
- Money creation: bank lending is the principal source of money creation (deposits). Growth in private sector credit has slowed from 7.1% YoY in September 2022 to only 0.3% YoY in September 2023.
The slowdown in M1, while dramatic, is neither an indicator of liquidity problems for EA banks nor a reliable indicator of economic activity or future inflation. At least, not in itself.
Last month’s money flow data illustrates this well. Despite on-going outflows of overnight deposits, M3 (the ST liabilities of the banking system) increased by €73bn in September 2023 and bank liability flows totalled €134bn.
Policy normalisation leads to natural re-adjustments in the structure and dynamics of MFI consolidated balance sheets (see future posts). This can and does create dramatic movements in individual items and monetary variables such as M1 and increases the risk of misinterpretation.
Context is required, therefore, including full analysis and understanding of both the components and counterparts of money supply.
In short, monetary aggregates still matter. They tell us a great deal about the interaction of the banking sector and the wider economy, but they need interpreting with due care and attention…
One line captures the attention
Growth trend (% YoY) in narrow money (M1) (Source: ECB; CMMP)
Narrow money (M1) fell by -10.4% in August 2023 (a record, see chart above) and by -9.9% in September 2023, driven by sharp declines in the level of overnight deposits (-12.0% and -11.4% respectively).
Broad money growth (% YoY) and contribution breakdown by component (ppt) (Source: ECB; CMMP)
The chart above illustrates the contribution of the three components of money supply – narrow money (M1), other short-term deposits (M2), and marketable instruments (M3-M2).
With M1 contributing -7.2ppt to an overall -1.2% on broad money, it is immediately clear that other important dynamics are at play here. These include the rising opportunity cost of holding overnight deposits, on-going portfolio rebalancing and the mechanics of money creation.
Opportunity cost
Growth trend (% YoY) in other ST deposits (M2-M1) (Source: ECB; CMMP)
Unprecedented tightening by the ECB has led to a rapid increase in the opportunity cost of holding overnight deposits. This is in sharp contrast to most of the past decade. This has triggered a partial reallocation of ON deposits to better-remunerated, other ST deposits. M2-M1 has been growing by more than 20% YoY since March 2023 and grew at a record rate of 24% YoY in June 2023 (see chart above).
Portfolio rebalancing
Trends in stock (EUR bn) and annual growth rate (% YoY) of LT debt securities (Source: ECB; CMMP)
The phasing out of net asset purchases and TLTROs has incentivised the issuance of bank bonds (see chart above). This has led to a portfolio rebalancing away from deposits to longer-term liabilities that do not form part of monetary aggregates, by definition. (See “Happier times ahead for FIG DCM bankers“, August 2023.)
Mechanics of money creation
PS credit growth (% YoY) and contribution breakdown by component (ppt) (Source: ECB; CMMP)
The principal way in which bank deposits are created is through commercial banks making loans. Banks are not simply intermediaries that take in deposits and then lend them out (“loanable funds theory”). Banks create money instead. Growth in private sector credit peaked, however, in September 2022 (7.1% YoY) and has slowed to 0.3% YoY in September 2023 (see chart above).
What does this mean for monthly financing?
Monthly financing flows (EUR bn) for September 2023 (Source: ECB; CMMP)
The table above illustrates monthly financing flows to the euro area and highlights the working of these dynamics in practice.
- Outflows of M1 fell from €75bn in August 2023 to €5bn in September 2023
- At the same time, flows into M2-M1 increased from €39bn to €74bn, while flows into M3-M2 totalled €4bn
- Hence, on a net basis, flows into the ST bank liabilities (“money”) were €73bn
- Note that flows of LT liabilities also increased to €38bn in September 2023, comprising €18bn of deposits with maturity of over 2 years and €14bn of debt securities with a maturity of over two years.
Conclusion
Policy normalisation leads to natural re-adjustments in the structure and dynamics of MFI consolidated balance sheets (see future posts). This can and does create dramatic movements in individual items and monetary variables such as M1 and increases the risk of misinterpretation.
Context is required, therefore, including full analysis and understanding of both the components and counterparts of money supply.
In short, monetary aggregates still matter. They tell us a great deal about the interaction of the banking sector and the wider economy, but they need interpreting with due care and attention…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.