To what extent should policy makers be tracking money supply in setting interest rate policy? At a time when economic growth in most countries is above its long run rate there is a debate about when and how much should interest rates increase. Whilst money supply indicators are normally not good indicators of future economic policy requirements due to unreliability of measurement, in this situation they do provide useful information that policy makers should take heed of.

Generally we would expect that when money supply indicators are growing faster than interest rates plus growth rate or inflation, whichever is higher, interest rates should possibly be increased. This should only generally apply when broad measures of money supply growth are higher than narrow measures, to rule out some of the measurement error issues that could emerge.

Using this indicator would suggest that UK interest rates have correctly been increased recently but further increases would not appear to be self evidently certain. Japan would appear to have no need to increase interest rates just yet, whilst the Euro zone and the US can wait a little further before applying interest rates to ensure that the economy does not overheat.

We will keep track of our theory over the rest of the year to see how it applies.