RDP 8805: The Relationship Between Financial Indicators and Economic Activity: 1968–1987 7. Conclusions

The evidence in this paper suggests that big changes in financial conditions are associated with big changes in private demand. This conclusion holds whether demand is measured in nominal or real terms.

The most useful financial indicators, in the sense of having a consistent, leading relationship to real private demand, are short-term interest rates and M1 (though these do not seem to be completely independent). The process of deregulation does not appear to have weakened the relationship between interest rates and real demand; if anything, that relationship has strengthened over recent years. For M1, however, there may have been some shift in the relationship recently.

The other banking aggregates were useful as leading indicators of real demand in the mid 1970s, but have been less useful since; they were particularly poor indicators in the early 1980s. Broader aggregates have a good relationship with real private demand, but their usefulness is confined to confirming what the indicators from the real economy have already suggested. There is also evidence of a shift in the relationship of broad lending and credit aggregates to real demand in recent years.

Nominal interest rates have been less useful as an indicator of growth in nominal private demand during periods of high and variable inflation, such as in the early and mid 1970s. (Since 1983, the relationship of nominal interest rates to nominal demand has improved noticeably.) The banking aggregates generally performed much better than nominal interest rates as indicators of nominal demand in such periods. This suggests care in the use of interest rates as indicators. When inflation is changing noticeably, some measure of the real cost of borrowing (even though necessarily crude) will be an important additional indicator.

It is also possible that the usefulness of the banking aggregates, relative to interest rates, as indicators of nominal demand in these earlier periods may have been a function of the regulatory environment. This question has not 4een addressed in this paper; it will be taken up in a later paper in this series. But there is evidence that these aggregates have failed as indicators at crucial times in the 1980s.

Broader aggregates are also closely related to nominal demand; there is less of a lag here (and in some cases, a leading relationship) than in the relationship to real demand. There is, however, evidence of a shift in the relationship since deregulation. The broad lending and credit aggregates have been growing much faster than nominal demand in recent years, and there is now no evidence that they lead nominal demand.

In comparing the results obtained from the real and nominal activity indicators, there is also an implication that movements in real demand tend to precede movements in inflation. This would help to explain, for example, the lengthening of the leading relationships (between many of the financial variables and demand) when the nominal demand results are compared with the real demand results.

While the paper has not sought to discuss relationships in terms of causality, the data, particularly for the deregulated period, do suggest a certain temporal ordering. Since deregulation, that ordering can be characterised as follows: interest rates move first, followed by M1. Real private demand moves immediately and for the next year. Nominal demand moves a little later. Other financial aggregates tend to move with, or a little later than, real private demand and coincidently with nominal demand.

Any description of the monetary “transmission mechanism” must be consistent with that ordering. This is a topic for a future paper.