Fighting inflation in leading economies: a medium term task

Last week, in an event organised by the IEA, my colleague from the IIMR, Tim Congdon, and myself stressed that annual money growth (broadly defined) must return to under 5% to bring inflation down to 2% a year. According to the latest monetary data available, the US, the Eurozone and the UK do not fulfil this condition. As reported by IIMR in its January 2022 money update (see table below), broad monetary growth in the US has accelerated in recent months, with an annual 9.8% rate of growth of M3, a figure well above that compatible with 2% price stability. In the Eurozone, monetary growth (M3) has also accelerated recently and is also too high (7.3% annual growth). The same applies to the UK (6.9% annual growth in broad money), though in this case the rate of growth of M4x has decelerated in the last few months.

Broad monetary growth world-wide

See IIMR January 2022 money update at https://mv-pt.org/monthly-monetary-update/

Here you will find two videos with our inflation forecasts for the US and the UK. In both cases, we use the quantity theory of money as the theoretical benchmark to make our analysis and projections of inflation for 2022- 2024. As Milton Friedman put it, there are “long and variable” lags between money growth and inflation. This is why, even if money growth fell to under 5% a year in the next few months, these lags mean that 2022, and probably 2023, will see inflation in the 5 per cent – 10 per cent area. This is because of the excess in money balances created in 2020 and 2021. Bringing inflation back to the central bank definition of price stability is a task for the medium term. Of course, ultimately the rate of inflation in the next two or three years will very much depend on the reaction central banks will take in the next few months to the current inflation episode.

We used this same approach in a report written for the IEA in the spring 2020 when Tim Congdon and myself anticipated an inflation boom in the US in 2021-2023. A key element in our analysis and forecasts is that changes in money velocity revert to their mean, as the data shows (see below the reversion to the mean pattern observed in the US in the last century). This means that the surge in the demand for money (and thus in money velocity) in 2021 will gradually cease as it has started to happen and eventually return to its 2019 levels, therefore pushing spending and prices up. More details in the presentation on the US below.

Castañeda, Cendejas, Congdon (2021). Presentation at IIMR 2021 conference. See https://youtu.be/cmhcLljq-Vk

The video presentation on the US inflation forecast comes from our contribution to the IIMR 2021 conference (“The 2020 money supply explosion and ensuing inflation”) and our comments on the UK from a recent interview we had with the IEA Head of Public Policy, Matthew Lesh.

Comments welcome.

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Central banks are not just interest rate setters

Central banks are not just interest rate setters: an introduction to modern central bank roles

This is the online presentation I made at the 2020 Freedom Week (by the Adam Smith Institute and the Institute of Economic Affairs) on August 21st. It is an overview of the major roles undertaken by modern central banks in our economies, which involves much more than setting the policy rate. Actually, since the outbreak of the Global Financial Crisis what leading central banks have been doing is to act as ‘bank of banks’, ‘bank of the government’ and, as regards monetary policy, to engage in asset purchase operations (i.e. Quantitative Easing). Once policy rates were brought down to the effective lower (nominal) bound, central banks have used outright asset purchases to be able to affect macroeconomic outcomes. Contrary to a very popular misperception, in purely fiat monetary systems, central banks cannot run out of ammunition, even when nominal policy rates are zero or close to zero. In this presentation, I briefly discuss (1) what central banks do as providers of services to the banking sector and to the government, as well as (2) the importance of monetary analysis to understand the effects of changes in the amount of money on inflation and output over the medium to the long term. This is at the core of what we do at the Institute of International Monetary Research.

I hope you find it a good introduction to central bank roles in modern economies. As ever, comments welcome.

Juan Castaneda

PS. If only for enjoying James Gillray‘s caricatures as a means to explain money and central banking, it may well be worth watching.

 

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The problem of asymmetry in a monetary union the Eurozone must address

In a fixed exchange rate system such as the euro symmetry in the application of the standard is key for the well running of the currency and even its preservation over the long term: i.e. surplus countries should overspend and run deficits (either private or public or a combination of both) so they suffer from an excess of money in the economy and thus ultimately higher inflation. And just the opposite in case of deficit countries within the euro standard, as they need to cut down their spending in order to cut costs and prices and ultimately regain competitiveness. This was for long considered, if only implicitly, as the main ‘rule of the game’ in the running of the classical gold standard at the time.

Of course we have heard about the application of adjustment policies in deficit countries in the eurozone during the recent crisis, the so-called ‘austerity policies’; or in the technical jargon, policies aimed at achieving ‘internal devaluation’ as an external devaluation is not possible at all. However, it is important to remember that it is the running of both policies in surplus and deficit countries what would lead to a balanced macroeconomic equilibrium over time in the eurozone. Just looking into the 2018 balances of each country (to be precise, each national central bank) in the Target2 payments settlement system in the Eurozone, we can see how far we are from symmetry in the area. Actually, the balances have been deteriorating quite dramatically since the summer of 2007; and now we have countries like Germany holding a significant creditor position against the rest of the Eurozone countries (and particularly against Italy and Spain) of nearly 30% of the German GDP.

 

Source: Institute of International Monetary Research, Monthly Update (2018). From ECB data. 

 

The gold standard is often taken as a predecessor of the euro standard; true, both systems are based on the commitment to fixed exchange rates but the euro standard is much more stringent and demanding in that it is a ‘monetary union‘ (and not simply a ‘currency union‘ as the gold standard was, where national currencies ran at the announced fixed exchange rate and were ultimately governed by the national central banks). In an monetary union such as the euro standard the need to abide by symmetry, by both surplus and deficit member states, is even more difficult to articulate and achieve: the states do not longer have their national central banks to inject or withdraw money as needed be, and symmetry can mainly be achieved by expanding or tightening fiscal policy (and also by supply-side policies, that are indeed needed but take a longer time to be effective).

Along with two colleagues of mine, Alessandro Roselli (Cass Business School) and Simeng He (University of Buckingham) we have conducted a research on the measurement of asymmetry in the running of the gold standard from the 1870s to 1913. As shown in the table below, only the hegemonic economy, the UK, abided by symmetry, whilst the other 4 major European economies at the time did not (see table below).

See the following link for further details on our paper: https://www.researchgate.net/publication/328562649_A_measurement_of_asymmetry_in_the_running_of_the_classical_gold_standard

This is an extract from the paper with a summary of our conclusions, with striking parallels on the situation of the euro standard and the asymmetries mentioned above:

‘The consequences resulting from the running of the gold standard with a deficient degree of symmetry should not be underestimated, as countries like Germany and France refused to let the increase in reserves to be reflected in a greater amount of money supply. This created tension in the system, as countries like Italy or Spain would find it more difficult to regain competitiveness, and thus a greater internal devaluation was needed to be able to compete with their trade (surplus) partners.

Were the asymmetries of the pre-WW1 period the origin of the gold standard’s final collapse? The straight answer is negative: all the five countries here surveyed had to suspend the standard at the outbreak of the war, if not before such as Spain in 1883; it was the War, with the huge expansion of the money supply, dramatic inflation and social unrest that made later in the 1930s the gold standard unable to survive. In the post-war period, Britain had lost her hegemonic status and symmetry together with it.  (…) the asymmetry of the hegemonic country (the US) under the Bretton Woods System might well explain its collapse.

Should we infer from these experiences that symmetry of the hegemonic country is the precondition for a fixed rate system (or for a currency union with a single currency) to survive? And, referring to the Eurozone, should we think that Germany – unquestionably the hegemonic country – is behaving asymmetrically and that the Eurozone should collapse as a consequence? Another paper would be needed to answer these questions.‘

Some claim the Eurozone must be completed with a full fiscal (budget) union, so a meaningful ‘federal EU budget’ can transfer resources within the area when needed; however, even if politically feasible, this option will take time to take place and the imbalances within the Eurozone keep on accumulating day by day. There are pressing issues resulting from the lack of symmetry in the running of the euro standard no one can now deny: How are the Target2 balances going to be settled, if they will be at all at some point? Can persistent trade imbalances among member states run within Eurozone countries? Can more flexible goods and services as well as labour markets reduce asymmetries within the Eurozone enough? Can the Eurozone force surplus countries to be more expansionary when needed be?

The eurozone member states clearly opted for a more centralised monetary union during the crisis, and the questions above are some of the key questions still pending to address for the euro standard to stop accumulating internal asymmetries. The other option would have been to abide by the no bail-out clause stated in the Maastricht Treaty and the application of the subsidiarity principle in the construction of the eurozone, and thus let errant countries fail if they could not fulfil the strict requisites to remain in the eurozone; but this was clearly not the option taken.

 

Juan E. Castaneda

PS. For information, we will address these issues in a conference on ‘The Economics of Monetary Unions. Past Experiences and the Eurozone’ at the University of Buckingham (21-22 February 2019). Please check the speakers and the programme online should you want to attend (by invitation only).

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Is the central bank a bank at all? The case for a privately-owned central bank

Last month I had the pleasure to contribute to the IIMR/IEA annual monetary conference (8 November 2017) in London, ‘Has Financial Regulation Gone Too Far? And do banks really need all the extra capital?‘. I gave a short talk in session 3, ‘The role of the central bank in financial regulation‘, chaired by Charles Goodhart (LSE), on the essential nature of central banks as banking institutions. It may sound silly to state the obvious but, as my good friend, mentor and excellent colleague – Pedro Schwartz – always reminds me, we should not take for granted the fundamentals in economics, even less in money and central banking. Let me then start by saying that modern central banks were established to cope with two major tasks: (1) to be the bankers of the State (the Bank of England and other continental European central banks are good examples of this, see here) but also (2) to become the bankers of the banks in monetary systems operated under a fractional reserve (again, the Bank of England is the first modern central bank in this regard); the latter is what we call the lender of last resort function of central banks.

In the early years of the establishment of central banks, with the running of the gold standard, strictly speaking, there was no monetary policy nor the pursue of a macroeconomic target as we understand it now; but a bank of issue with a privilege position in the monetary market, and mainly focused on maintaining the convertibility of its currency at the pre-announced rate. It was only quite recently (historically speaking), after the abandonment of the gold standard in the interwar years, that central banks have explicitly adopted or given other tasks, and indeed macroeconomic tasks, such as keeping price stability or achieving economic growth.

But we should not forget that central banks are at the core of the monetary system and the banking sector, providing financial services to a ‘club’ of commercial banks which create money in the currency issued by the central banks. Which money? ‘Bank money’, that is, bank deposits under a fractional reserve system. This money constitutes the bulk of the money supply in modern economies, and it is vital for the central bank to keep a steady growth of the amount of money in circulation to preserve stable and long term economic growth; thus avoiding too much money during the expansion of the economy or too little in a banking crisis. What I state in my talk is that privately-owned central banks are genuinely interested in maintaining financial stability, and thus will be willing to intervene in a liquidity crisis much more promptly and efficiently than a central bank under the shadow – if not the control – of the State. This is something I have supported in other articles (recently in this article), and my colleague at the IIMR, Tim Congdon, has written on (see chapter 7 in ‘Central Banking in a Free Society‘).

This is the video of the talk:

Comments are very welcome as ever!

 

Juan Castañeda

PS. To the best of my knowledge the characterisation of central banks as the bankers of a ‘club’ was first coined by Charles Goodhart in his seminal 1988 book, ‘The Evolution of Central Banks‘, a book anyone interested in the history and functions of central banks must read. However, unlike Goodhart’s position in his book, I do not see a conflict of interest for a self-interested central bank to become a lender of last resort in times of crisis. Actually, central banks did make a profit when lending in times of crisis, such as the Bank of England in several banking crises in the 19th century.

 

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