For starters: they printed way too much and for too long. We all know this, but why didn’t central banks figure it out? Partly because they ignored a very basic tenet of economics – the growth in the supply of money matters for inflation dynamics.
Milton Friedman famously proclaimed that inflation is “always and everywhere a monetary phenomenon” – a problem of printing too much money. Every commentator likes to pull this quote out, but despite its hackneyed overuse, it was ignored on the grounds that the correlation between money supply and inflation had broken down. Austerity and banks’ desire to rebuild capital meant money growth in the wake of the global financial crisis did not lead to inflation. But the opposite forces have been working because governments allowed their debts to balloon by going on a spending spree. Central banks were complicit in funding this debt – effectively monetizing issuance – in a phase that was similar to the 1940s when the US was funding WW2.
Jay Powell, the Federal Reserve chair, didn’t think money growth mattered. Speaking in February 2021, he said: “There was a time when monetary policy aggregates were important determinants of inflation and that has not been the case for a long time.”
He added: “The correlation between different aggregates [such as M2, a measure of money in the US economy] and inflation is just very, very low, and you see that now where inflation is at 1.4 per cent for this year. Inflation dynamics evolve over time, but they don’t tend to change overnight.”
Even as recently as May 2022, Andrew Bailey, the governor of the Bank of England, stated that: “What I reject is the argument that in our response to Covid, the Bank's Monetary Policy Committee let demand get out of hand and thus stoked inflation. The facts simply do not support this.” “Not our fault gov”, he may as well have said.
Last year the European Central Bank confessed it got its inflation forecasts wrong. We could all see this for ourselves, but it was nice of them to admit it – even if they then shirked the money growth question. They argued that the reason for their consistent errors was “largely due to exceptional developments such as unprecedented energy price dynamics and supply bottlenecks”. In this entire paper there is not a single mention of money growth or related terms.
How could we all see it and yet be told not to believe our eyes? Thankfully some good folk at the central banks’ schoolmaster have done some research and told us what we knew to be true. In a new bulletin, the Bank for International Settlements (BIS) says that looking at money growth would have helped to improve post-pandemic inflation forecasts, suggesting that its information value may have been neglected. Well duh.
Across various countries, it says, there is a statistically and economically significant positive correlation between excess money growth in 2020 and professional forecasters’ misses of inflation in 2021 and 2022. The authors ask: “Could incorporating information about money growth have helped to improve the forecasts of professional economists? This is a tougher test because these forecasts presumably contained all the information available to forecasters when they were making their projections. The answer appears to be ‘yes’.”
The authors of the report also note that a link can be seen in the recent possible transition from a low to a high-inflation regime. “An upsurge in money growth preceded the inflation flare-up, and countries with stronger money growth saw markedly higher inflation,” they write.
The US printed – and we should note it’s not just the Fed here but the US Treasury – something like $7 trillion in two and a half years. What did they think would happen? As the great investor Paul Tudor Jones explained in May 2020 in an important letter to investors on the subject of the ‘Great Monetary Inflation’ (which has guided much of my thinking since then): monetary expansion alone is not sufficient to generate inflation. In the wake of the global financial crisis, unending quantitative easing failed to produce inflation as banks absorbed the increase in money to bolster their liquidity and capital requirements. This time was always going to be different because of the direct fiscal stimulus that accompanied the central bank activity. Everyone else could see that printing all that money would likely cause inflation. So why didn’t Powell and co see it too?
And all this matters now because shifting from a high inflation regime to a low one is very difficult. We are on the verge of a “paradigm shift” in the global inflation regime, the BIS warned last year. We are at the point of inflation becoming entrenched – and it is always very difficult to banish it once it comes. In the more recent bulletin, authors Claudio Borio, Boris Hofmann and Egon Zakrajšek conclude: “Might the neglect of monetary aggregates have gone too far? In the end, only time will tell.”
Neil Wilson is the Chief Market Analyst at Finalto
