A neglected tool of central banks shows its worth
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Money supply numbers have long been an orphan in the tool kit of the big central banks. This is unfortunate because the numbers have been sending important signals before and during the pandemic.
Economists at the Bank for International Settlements have found a statistically and economically significant correlation across a range of countries between excess money growth in 2020 and average inflation in 2021 and 2020. And you do not have to be an out and out devotee of the quantity theory of money to see that the buoyancy of US house prices and equities last year was substantially about too much money chasing too few assets.
There is, of course, a reason for this central bankerly neglect of money. In the heyday of monetary targeting in the 1980s central bankers — most notably Paul Volcker at the US Federal Reserve — were remarkably successful in bringing down inflation from record postwar levels after successive oil price shocks, although this came at the cost of savage recessions. Subsequently the link between money supply and inflation weakened.
This was down to velocity, the measure of how often money changes hands. When this happened at a predictable pace, money and output grew together. At the same time there was a clear relationship between inflation and excess money growth — the difference between money growth and growth in real gross domestic product.
But as inflation came down in the 1980s and 1990s velocity became highly unstable, in part because of financial innovation and changes in banking regulation. So the link between money supply and nominal GDP broke down and the information content of money supply numbers became a less helpful guide for policy. As trying to fathom the numbers became more complicated monetarism went out of fashion. The exception was when central bankers confronted financial crises, where they reserved the right to turn on the monetary hosepipe.
Interpreting money numbers was once again conspicuously difficult after the financial crisis of 2007-09. Monetarists warned that the stimulus from the Fed’s asset buying would lead to rapid inflation. Yet velocity dropped sharply and the outcome was a strange combination of asset price inflation and the threat of deflation in prices of goods and services. Why, then, are the figures now telling a clearer story?
In the recent BIS study, Claudio Borio, Boris Hofmann and Egon Zakrajšek found that the strength of the link between money growth and inflation across a large sample of advanced and emerging market countries depended on whether there was a high inflation regime or a low one. In a high inflation regime the link was one to one; in a low regime it was virtually non-existent.
The BIS authors point out that the recent flare-up in inflation was preceded by an upsurge in money growth. Countries with stronger money growth saw markedly higher inflation. Yet they caution against assuming causality, arguing that the debate on this has not been fully settled. But, they add, money growth figures can still have useful information content for inflation.
There are many other reasons why central banks failed to foresee the inflation flare-up. Their economic models often relied heavily on extrapolations of the recent past and assumptions about the economic cycle. Clearly the pandemic and the war in Ukraine were exceptional events that had nothing to do with any cycle.
At the same time the central banks’ asset purchasing programmes have distorted market expectations. Otmar Issing, former chief economist and board member of the European Central Bank, now at Goethe University in Frankfurt, argues that investors with higher inflation expectations have tended to sell their bonds to central banks at prices they regarded as high. As a result these inflation pessimists have been absent from financial markets, causing the thermometer of inflation expectations to read lower than the actual temperature. A more obvious point is that central bankers badly underestimated the second-round effects of oil and food price hikes in labour and other markets.
The risk of not looking at money now lies in the other direction. The Fed has been tightening, as have others. Steve Hanke and Caleb Hofmann of Johns Hopkins University say that by December last year the three-month annualised growth rate of broad money (M2) in the US had sunk to a stunning minus 5.4 per cent pushing the year-on-year growth rate into negative territory. One conclusion: the equity market is currently too sanguine about avoiding a recession. Another: time for a rethink about money.