Opinion: Anti-inflation policy is all about the money

 

When the current inflation began the Bank of Canada assured the public it was caused by the pandemic’s temporary disruption of supply chains and would not last. But the price increases persisted and the Bank changed its mind and has begun raising interest rates to reduce the demand for goods, services, and assets and try to prevent a dreaded wage-price spiral. That the Ukraine war has disturbed key markets has not helped.

In contrast, the academic economists known as monetarists have insisted from the start that the inflation was due, not to temporary disruptions in supply or to international tensions, but rather to an excess supply of money the Bank of Canada itself created. This view is based on Milton Friedman’s conclusion, after studying past inflations around the world, that “Monetary policy is not about interest rates; it is about the growth of the (broad) quantity of money.” Combatting inflation requires adjustments to the money supply, not changes in interest rates.

Canada’s money supply, as measured by “M3,” grew by 32 per cent (from $2.5 trillion to $3.3 trillion) between the second quarters of 2019 and 2022. During the same period the country’s GDP increased 22 per cent. If the Bank had kept the ratio of money to GDP constant, the money supply would have increased 22 per cent or $0.6 trillion, not 32 per cent or $0.8 trillion, which implies the excess money supply held by the Canadian public in 2022 was some $200 billion.

Since this extra $200 billion was more than Canadians needed to carry out their financial affairs, they disposed of it by spending it on goods, services and assets. But all this new demand was not accompanied by an equivalent increase of production, which is what would have happened under normal conditions when Canadians earned money in return for producing goods and services. In fact, the Bank of Canada created this excess money supply with the stroke of a pen. The result — “more money chasing the same amount of goods” — led to inflation.

It’s probably counter-intuitive and it’s certainly ironic that spending by some Canadians to lower their money holdings does not decrease the overall money supply. The reason is that the money that sellers of the goods, services and assets receive becomes their own excess money holdings. When they in turn spend it, the surplus money is shifted to another set of sellers — and so on and so on in a vicious cycle. It is like a hot potato no one wants to hold that is passed around the room from person to person. In the end, the excess money supply is eliminated only when inflation reduces its real value or central bank operations soak it up directly.

The Bank of Canada created the excess supply mostly in the second quarter of 2020, when M3 grew eight per cent, four times its normal growth of about two per cent. Why did it do that? To provide the federal government with the money it needed to bring financial relief to needy Canadians affected by the pandemic. That burst of government spending was justifiable on moral grounds. What was not justifiable was the Bank’s failure to reduce the money supply to non-inflationary levels after the emergency relief payments were no longer needed.

While some Canadians spent the excess money, others have been using it to finance a period of leisure. Their withdrawal from the labour force helps explains why there is the shortage of labour that has led to higher wages, inflation and the beginnings of a wage-price spiral.

Monetarists believe another important problem confronts the Bank of Canada. It can only set nominal rates of interest. But borrowing and spending are determined by real rates. If expected inflation is eight per cent, an apparently high nominal rate of interest of six per cent in fact becomes a real rate of minus two per cent. You could borrow $100 at six per cent, buy an asset, sell it a year later for $108, repay the $100 loan, pay the $6 interest due and enjoy a net profit of $2. When real interest rates are negative borrowing always pays and lending becomes a mug’s game.

But inflationary expectations are not observable. So the Bank does not know what real rate is implied by the nominal rate it sets. Operating in the dark in this way can lead it to set nominal rates too low, which unintentionally creates inflationary increases in demand, or too high, which risks unnecessarily large reductions in demand and a recession.

Canadians can only hope the Bank of Canada’s interest rate policies will get inflation under control promptly, despite the problems identified by monetarists. If not, we are in for a deeper recession, higher unemployment and lower economic growth than necessary.

Herbert Grubel is an emeritus professor of economics at Simon Fraser University and a senior fellow at the Fraser Institute.

Published in the Financial Post, Oct 20, 2022