To understand and forecast inflation, follow the
money
Former
Bank of Canada Governor John Crow was once asked whether the money supply had
been used in the Bank’s economic model and forecasts he had just
presented. His response was that although money was not in the model he
regularly looked over his shoulder to be sure the money supply was not growing
too quickly. During his time in office, both the money supply and prices grew
at satisfactorily moderate rates.
Current Governor Tiff Macklem
should have spent more time looking over his shoulder. In the first year of the
COVID epidemic the money supply, as measured by “M3,” increased
at an average annual rate of 13.4 per cent, almost double the rate during the
preceding nine years. Even so, most academic economists and advisers to central
bankers have blamed the current inflation — 8.1 per cent year-on-year in June —
on disruptions in the global supply chain, COVID after-effects, the war in
Ukraine but not excess money creation. In the press conference last month at
which he announced a hike in the Bank’s target interest rate of 100
basis points, Governor Macklem did not mention the money supply once. Nor was
the issue raised during later media interviews.
But money
is crucial to inflation. In the words of Milton Friedman: “Inflation is always and everywhere
a monetary phenomenon in the sense that it is and can be produced only by a
more rapid increase in the quantity of money than in output.” History
shows that inflation follows excessive growth in the money supply with a lag,
usually about two years.
Events
like harvest failures, epidemics, floods, earthquakes, and wars do of course
reduce supply and increase the prices of goods and services affected by
these abnormal events. But these price increases disappear once normal
conditions return. If they were to persist, consumers spending more on the
higher-priced goods would have less income to spend on other goods, whose
prices would fall correspondingly, leaving the average of all prices unchanged.
Inflation, a persistent increase in the overall price level, can therefore only
occur if increases in the money supply precede or accompany these disturbances.
What
causes the money supply to increase? The first way involves commercial banks
extending loans to private borrowers, granting them a corresponding amount of
new current account deposits, which count as money in government statistics.
These commercial banks see their assets (the loans to the borrowers) increase
by the same amount as their obligations (the new money in the deposit accounts
that the banks have created for the borrowers).
A second
way the money supply can increase results from actions of the Bank of Canada.
During COVID, the bank bought government bonds held by investment institutions.
It paid for them by creating new deposits for the sellers. This added
directly to the money supply and increased the central bank’s assets and
liabilities by the same amount. Known as “Quantitative Easing,” (QE) this
policy likely helped keep interest rates low: when a central bank buys bonds
that makes things easier for people and firms trying to borrow money.
Both commercial and central banks in effect create
money out of thin air. The ability of the commercial bank to do so is
constrained by regulations and interest rates set by the central bank, which
influence private lending and thus the growth in demand for loans. The Bank of
Canada, however, faces no limits on its money creation other than public
and political pressures when the economy underperforms or inflation develops.
The total
amount of money created by Canada’s commercial banks and the Bank of Canada is
known as M3. The share of money created by
the Bank of Canada in
the decade before COVID was three per cent but soared to 46 per cent in
2020-2022, which implies strongly that expansion of the money supply moved
dramatically from the market-determined actions of commercial banks to the
politically determined policy of the Bank of Canada.
The two
lines in the nearby graph show six-month moving averages of monthly
observations of year-over-year growth in inflation and money supply, with the
twist that while the inflation numbers are current the money supply data is
from two years earlier, which makes it possible to judge how much it may
influence subsequent inflation.
In the
early years, as the graph shows, fluctuations in both variables were moderate.
Even so the correlation between them was surprisingly strong, given other,
non-monetary factors that also affected prices. The correlation after early
2020 is unmistakable, however, and supports the “monetarist” view that excessive
growth of the money supply is the underlying source/driver of the current
inflation.
What does
the model say about future inflation? The vertical line marks May 2022, the
latest data available at the time of writing. The single line to the right of
it shows the M3 created over the past two years, which, according to the
monetarist model, will largely determine inflation in the coming two
years. The line suggests inflation will peak this autumn when the high
15.2 per cent M3 growth has worked its way through the system. The
subsequent reduction of M3 growth will exert some downward pressure
on prices — but only for a short time since the slowdown has now been replaced
by another period of accelerating M3.
We
conclude that inflation could accelerate again in mid-2023 and continue
well into 2024. As always, this projection may prove to be wrong if other
powerful economic developments occur — another wave of the pandemic, for
instance. Still, analysts would be wise to take the possibility seriously.
Excess growth
in M3 in recent years was caused by the perceived need to finance record fiscal
deficits, which QE did. These deficits and their monetization were made
politically possible by the government’s adoption of two revolutionary new
ideas in economics.
The first
was that budgets no longer had to be balanced over the business cycle. Rather,
deficits were fine so long as they did not bring the debt-to-GDP ratio above a
certain, reasonable level. In fact, overall government debt has
risen rapidly above any reasonable level from 86.8 percent of GDP in 2019 to
117.8 in 2022.
A second idea
underlying the extraordinary growth in the money supply was politicians’ ready
acceptance of “modern monetary theory,” which argues that governments can issue
unlimited amounts of money in their own currency without risk of
bankruptcy so long as inflation does not result. Inflation obviously has
resulted, but this view has been used to rationalize unprecedented peace-time
levels and growth in deficit spending.
These theories are
now being tested in the real world. The correlation between excess money
creation and inflation seen in the graph suggests they are likely to fail. But
only time, and possibly considerable economic distress, will bring the final
judgment.
Financial Post
John
Greenwood is chief economist of the International Monetary Monitor in London.
Herbert Grubel, MP from 1993-97, is emeritus professor of economics
at Simon Fraser University and a senior fellow at the Fraser Institute.
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