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Money's misleading message for inflation

The big rise in the money stock might not cause much inflation, but higher interest rates instead.
Money's misleading message for inflation

“Inflation is always and everywhere a monetary phenomenon.” If Milton Friedman’s famous line is right, we’re headed for rising inflation.

The Bank of England estimates that the M4 money stock – the bank deposits held by the non-bank private sector – has risen 13.6 per cent in the past 12 months, the fastest rate since 2006. Because of this Tim Congdon at the University of Buckingham and colleagues have warned that we could see inflation top 5 per cent at some time in the coming years.

Certainly, there is precedent for faster monetary growth to lead to rising inflation: we saw just this, for example, in the late 1980s. Equally, though, there are cases of it not doing so. Accelerations in monetary growth in the mid-1990s and mid-2000s didn’t lead to significant inflation.

There are two general reasons why the link between monetary growth and inflation is uncertain. Both apply now.

One is that the demand to hold money rather than spend it can vary. In the past 12 months, households’ bank deposits have risen 12.1 per cent, their fastest rate since 1991. This has happened because in keeping us out of pubs, restaurants and some 'non-essential' retailers the pandemic has forced us to save more. It’s likely therefore that there are excess monetary balances waiting to be spent and so we’ll see a boom in demand. If we assume that bank deposits would have risen 5 per cent but for the pandemic then there is almost £150bn of excess money waiting to be spent – equivalent to over 10 per cent of normal annual consumer spending.

But are excess balances really this great? Or will the change in habits forced upon us by the pandemic prove partly permanent? If so, we might remain more frugal than we used to be and hold onto some of our higher savings – although perhaps eventually shifting them from cash into other forms of saving?

The second issue is: will increased demand (which of course we will see to some extent) lead to rising prices? One reason why monetary expansions in the mid-1990s and mid-2000s did not do so was that stronger demand sucked in imports instead. That could happen again.

What’s more, how much inflation we get depends on supply-side conditions such as the degree of spare capacity or extent of product market competition. If we see a swathe of business closures, reduced capacity and less competition will foster inflation. If we don’t, then inflation won’t be so responsive to increased demand. We don’t yet know the answer to this. And certainly, money stock numbers tell us nothing useful.

None of this is to deny that monetary growth might lead to significantly higher inflation. Maybe it will. Instead, the point is to remember Charlie Munger’s wise words: “One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it.” We must know what we don’t know. And what we don’t know is whether the pandemic has caused behavioural changes that strengthen or weaken the link between monetary growth and inflation.

But we do know something – that central banks can reduce inflation if they really want to do so by raising interest rates. What seems to be an inflation risk might therefore in fact be an interest rate risk. And for many investors, this is bad enough.