13 April 2022

It’s the money supply, stupid


The experience of the last couple of years has demonstrated, once again, that if you continue to pump huge amounts of practically free money into economies which are already running close to capacity, the result is likely to be much higher inflation.

Indeed, the further rise in the UK CPI measure, to 7% in March, is a textbook example of too much money chasing too few goods and services.

This is not, unfortunately, what you are likely to read elsewhere. Most explanations of the latest inflation data simply focus on the individual prices that are rising the most, rather than looking at the bigger picture.

This mistake helps to explain why inflation has consistently been higher than almost everyone had expected. And this includes the Bank of England, which has largely ignored the monetary drivers of inflation for many years.

The US ‘market monetarist’ Scott Sumner (in his excellent 2021 book The Money Illusion) makes the point that ‘from 1968 to 1984, Milton Friedman won almost every battle but lost the war’. One explanation is that monetarists too often favoured a simple rule for monetary growth that assumed velocity was relatively stable.

I have often wondered myself why monetarist economics is so unfashionable. In the UK, it may not help that the Conservative government adopted a clumsy target for ‘sterling M3’ in 1979, or that many still associate ‘monetarism’ with other controversial policies adopted by Mrs Thatcher.

Sumner also observes that ‘we naturally gravitate towards stories with villains, whether they are greedy bankers, dishonest borrowers, or politicians trying to pressure regulators and banks to encourage more lending’. Perhaps we should now add greedy energy companies, and Vladimir Putin, to that list.

Monetary economics can seem complicated, too. It really should not be so. Most people intuitively understand the link between money and prices. But it is much easier for commentators to explain why the war in Ukraine is driving up the costs of energy and food, especially if the alternative is to bang on about ‘sterling M4 excluding intermediate other financial corporations (aka ‘M4ex’)’.

It probably does not help, either, that some of the leading proponents of monetary economics are what might be described as the ‘wrong demographic’. Being right, or at least adding real value, is no substitute these days for being trendy.

This is having real costs. Diversity used to mean appointing independent members of the Bank of England’s Monetary Policy Committee who have expertise in different fields, such as labour markets, housing, or asset prices. Surely room could be found for someone with a particular focus on monetary analysis.

Admittedly, even monetarist economists disagree on the outlook for inflation. There is at least a consensus that the long period of very loose monetary policy, both in the UK and elsewhere, means that inflation is likely to remain high for the rest of this year.

The exact monthly profile may well hinge on swings in global energy prices and changes in the Ofgem cap on domestic bills, but inflation is now widely spread across the economy.

However, views differ on 2023. This partly depends on whether you put more weight on the growth rate of the money supply, or the stock.

Optimists (myself included) like to note that UK broad money growth has already dropped sharply. (The annual growth rate of M4ex slowed to 5.0% in February, from a peak of 15.4% in the same month a year earlier.) This suggests that inflation will drop back sharply next year.

My own best guess is that UK CPI inflation will rise to around 8.5% in April, but this will then be the peak, and that inflation will be back at 3% by mid-2023.

However, others prefer to emphasise the stock of money. The policy of quantitative easing has created a large overhang of excess money that will take some time to unwind. This could keep inflation in the range of 5-10% for much longer.

Either way, the Bank of England needs to get serious about returning interest rates to more sustainable levels, and withdrawing more of the extraordinary monetary stimulus that has allowed inflation to take off.

This is a global issue. Other major central banks, including the US Fed and the ECB, therefore need to do the same thing.

In the meantime, there is little that anyone can do to change the outlook for inflation in the coming months. But a more credible approach to monetary policy would help to get inflation back down over the medium term.

At a minimum, there should be more discussion of monetary variables, including monetary growth, when assessing the outlook for inflation and economic activity. Central banks should explain how trends in monetary variables relate to their inflation mandates.

Ideally, the mandates themselves should be changed to put more emphasis on concepts such as nominal GDP. But in any event, we need to start talking more about money.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.