Economics Commentary: To understand and forecast inflation, follow the money

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.