- Money supply is contracting
- But this doesn't necessarily mean that inflation will fall…
If monetarists are right about inflation, we could be heading for trouble: money supply in the US has fallen sharply over the past few months. It is also dropping in the euro area, and recently stopped growing in the UK for the first time in more than 13 years.
As the chart below shows, there is a pretty neat correlation between money supply and the inflation rate a year-and-a-half later. If this holds in the months ahead, inflation looks set to fall precipitously. Forget the firm stance of central bankers: a period of ‘higher for longer’ interest rates could be the last thing we need.
According to monetarists, there is a stable relationship between the money supply and the general price level: when too much money chases too few goods, inflation is the inevitable consequence. This certainly seemed to be the case during the pandemic period. As the chart shows, money supply soared as policymakers embarked on huge stimulus packages. This translated into a large increase in deposits in the economy and in reserves on banks’ balance sheets – and 18 months later, the inflation rate surged.
But (as is often the case in economics), the relationship isn’t entirely straightforward. Last month European Central Bank executive board member Isabel Schnabel made a speech asking whether money growth still matters for central banks. The answer seems to be “it depends”. Schnabel concluded that “on its own, quantitative easing (QE) is not inflationary”. But it can easily become inflationary when “banks, households, firms and governments are both able and willing to respond to low interest rates, thereby boosting money growth, economic activity and, ultimately, inflation”. Macroeconomic context is key.
Felipe Villarroel, portfolio management partner at asset manager TwentyFour, points out that after the financial crisis, when QE was first unleashed, broad measures of money supply grew by only around 4 per cent in the eurozone, while growth fell close to all-time lows in the US. According to Villarroel, “in the aftermath of the collapse of Lehman’s, banks were in deep trouble and cut their lending dramatically”.
But during the pandemic period, the banking sector had much higher willingness to lend, and there was more appetite for borrowing among consumers and firms. As a result, broad money supply grew at the highest ever annual rate in the US, and at near-record rates in the euro area. When we compare this to the first tranche of QE, it becomes clear that not all episodes have had the same effect.
The impact of a fall in broad money supply will also depend on the wider macroeconomic context. In a note last month, Deutsche Bank strategist Jim Reid said that while it was easy to conclude that a huge spike in money supply two to three years ago would lead to high inflation, “it doesn’t seem such an easy call from now [on]”.
After all, there are several reasons to fear that inflation might not make a smooth descent back to target. Reid points out that fiscal policy has remained structurally looser today, even as monetary policy has tightened. Wage inflation is still high, and tends to be stickier on the way down than it is on the way up. There also remains the possibility of another cost-push price surge, and analysts are attuned to the fallout from conflict in the Middle East, as well as the possibility that oil prices resume their advance. Risks like these look increasingly important in the context of other comments made by the ECB’s Schnabel, who said excessive money growth can “entrench adverse cost-push shocks” as well as making them more persistent.
As a result, she said that the money supply has “predictive power for risks to price stability that central banks need to monitor carefully”. The link between money supply and inflation might not be entirely straightforward – but that doesn't mean we can afford to ignore it.
