Forty years ago—or about the last time we had inflation rates as high as today—central bankers had an unfortunate split with the money supply. It had proved too volatile and unpredictable to be a reliable partner in determining monetary policy, they concluded.
Gerald Bouey, the governor of the Bank of Canada at the time, famously lamented, “We haven’t let M1 down, M1 has let us down,” referring to the primary measure of the money supply.
But now some economists and central bank critics think it may be time for at least a little reconciliation.
A research paper from the University of Quebec in Montreal, professor Steve Ambler and CD Howe Institute associate director of research Jeremy Kronick, published this week by the institute, found evidence that there is still a link between the long-term trend in money supply growth and inflation . Furthermore, that relationship has remained intact over the past three decades, during which the Bank of Canada has pursued a 2 percent inflation target as its guiding policy target – largely ignoring monetary aggregates such as M1 and the broader M2.
“Getting money growth under control is critical to stabilizing inflation,” the paper concluded.
Mr. Ambler and Mr. Kronick are far from alone in scrutinizing the money supply. The current global inflation environment has raised many difficult questions about central banks’ beliefs and assumptions about the mechanics of inflation.
For some, especially those who question the prowess and even the motives of central banks, monetary inflation arguments offer a smoking gun. Central banks spiked the money supply through quantitative easing (and governments circulated it through pandemic relief); there was a huge rise in inflation, after some delay; that’s why central banks have created this monster by ignoring everything economist Milton Friedman has taught us about money. (“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can only be produced by a faster increase in the amount of money than in output.”)
Mervyn King, who served as Governor of the Bank of England from 2003 to 2013, recently wrote that the world’s central bankers have come to view their inflation targets as pillars in their own right – that as long as they can contain consumer inflation expectations, the target, inflation would always go back to that target. In doing so, he said, central bankers have neglected the economic mechanisms involved.
“The old idea that inflation is a reflection of ‘too much money chasing too few goods’ is more plausible than the view that it is driven solely by expectations,” he wrote in an op-ed published by Bloomberg. “The fact remains that we have experienced a substantial, if temporary, increase in broad money growth, and we are now experiencing a noticeable, if perhaps temporary, increase in inflation.”
But even Mr. Friedman himself acknowledged that the money supply was a bad target for central bankers to control inflation. The experience of the 1970s and early 1980s showed that effectively understanding shifting inflationary pressures in the near term simply did not work, nor did the pursuit of a money supply have nearly the desired effect on output and production. the prices.
Inflation targeting, on the other hand, worked wonderfully well for a long time. Until it didn’t.
Mr. Ambler and Mr. Kronick said that as long as the public’s inflation expectations remain firmly anchored around a central bank target, there does not appear to be very much of a correlation between short-term movements in the money supply and subsequent inflation rates. But when those expectations become detached from that goal, the relationship between inflation and money supply resurfaces.
The Bank of Canada has argued that has not yet happened. But its own corporate and consumer surveys suggest otherwise, at least over the usual two-year horizon on which the bank bases its interest rate policy.
The quarterly Canadian consumer expectations survey, published Monday, found that Canadians expect inflation to still be around 5 percent two years from now — a sharp increase from 3 percent in the third quarter of 2021. The monthly Business Leaders’ report from the bank Pulse’s online survey, also released Monday, estimated two-year inflation at 3.4 percent. While both consumers and businesses generally still believe that the Bank of Canada may eventually get inflation back close to its target, surveys showed cracks in that confidence.
Mr. Ambler and Mr. Kronick argue that as long as we are in this period of what they call “unstable” inflation, the money supply will be a crucial catalyst in keeping prices in check, and a valuable indicator of the inflation outlook. They said the central bank’s shift to reducing its holdings of government bonds — so-called “quantitative tightening” — is an important step to curb money supply growth, but they warned it could take as long as two years to do so. will translate into a reversal in the associated inflation trend.
“Money should be reintegrated into its forecasting and monetary policy processes by the Bank of Canada,” they wrote. “It would be a good start to measure these aggregates in a more timely manner.”
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