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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Money and inflation. The inflationary effects of Covid-19 crisis

Video of the presentation to the Centre for Global Finance (SOAS, University of London) on 12/5/2021, via webinar.

Summary points:

• The monetisation of enlarged budget deficits, combined with official support for emergency bank lending to cash-strained corporates, has led to extremely high growth- rates of the quantity of money (broadly defined) in leading economies, which are incompatible with price stability over the medium term. The excess in money balances by financial companies in 2020 has already led to a big bounce-back in financial markets and asset price inflation. In addition, once lockdowns are over and the pandemic is under control, the excess in money holdings by households and non-financial companies will result in higher nominal spending and output, and eventually CPI inflation.
• In sharp contrast with the aftermath of the Global Financial Crisis, the central banks’ response to Covid-19 crisis has resulted in an expansion of their balance sheets but also critically of bank deposits, and thus of the amount of money in the economy broadly defined (M3 in the USA). It is changes in the latter what explains changes in inflation over the medium term, and central banks should pay more attention in monitoring changes in broad money as effective leading indicators of inflation in 1-2 years.
• We are already seeing a significant increase in commodity prices, industrial prices and also in CPI prices in the USA. The extremely high growth rates of money seen in the USA since March 2021 (the highest rate in modern peacetime, over 25% year on year in 2020) will end up in an inflationary boom over the next few years. The duration and scale of the boom will be conditioned by the speed of broad money growth in the rest of 2021 and in early 2022; thus, on the reaction of the US Fed to rising CPI inflation in the rest of 2021 and 2022.
• The quantity theory of money provides a valid theoretical framework which relates trends in money growth to changes in inflation and nominal GDP over the medium and long term. More details on this analysis on the report by myself in collaboration with my colleague T. Congdon (IIMR) (https://iea.org.uk/publications/33536/), published in the spring 2020 by the IEA. More up to date data can be accessed at the IIMR website.

Video available below (on CFG’s YouTube channel) :

With thanks to the CGF for hosting the webinar.

Comments welcome.

Juan Castañeda

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Inflation; the next threat?

On the economic effects of the policy responses to Covid-19

Today the Institute of Economic Affairs (IEA, London) has just published a report by my colleague Tim Congdon and myself (Institute of International Monetary Research and University of Buckingham) on the debate on the expected inflationary vs. deflationary consequences of the current crisis. Of course there are many unknowns yet and we should not claim or have the illusion that we can forecast exactly inflation rates in the next 2-3 years. But what we can attempt is to do ‘pattern predictions’ (see Hayek’s 1974 Nobel lecture speech). Based on the monetary data available and the theoretical body linking changes in the amount of money to price changes over the medium/long term, we have observed in the last two months an extraordinary increase in the amount of money in most leading economies (certainly in the USA, with a rate of growth of money, M3, of 25% in April 2020). This comes from the implementation of quite significant asset purchases programmes (i.e. Quantitative Easing) and the (partial) monetisation of very much enlarged government deficits; a trend that will most likely continue for the rest of the year. It is both the extraordinary money growth rates seen recently, along with the expected persistence in monetary growth in 2020 what support our forecast of an inflationary cycle in the US (and in other leading economies, though to a lesser extent) in the next 2-3 years. The diagram below from the report says it all (see page 8).

More details in the report (IEA Covid-19 Briefing 7, June 2020) at:

https://iea.org.uk/themencode-pdf-viewer-sc/?file=/wp-content/uploads/2020/06/Inflation_the-new-threat25787FINAL.pdf. Also, the webinar presentation of the report with my colleagues Geoffrey Wood and Tim Congdon will be available soon at the IEA’s website/YouTube channel.

Juan Castañeda

Summary of the report (in pages 4-5):

• The policy reaction to the Covid-19 pandemic will increase budget deficits massively in all the world’s leading countries. The deficits will to a significant extent be monetised, with heavy state borrowing from both national central banks and commercial banks.

• The monetisation of budget deficits, combined with official support for emergency bank lending to cash-strained corporates, is leading – and will continue to lead for several months – to extremely high growth rates of the quantity of money.

• The crisis has shown again that, under fiat monetary systems, the state can create as much as money as it wants. There is virtually no limit to money creation. The frequently alleged claim that ‘monetary policy is exhausted at low (if not zero) interest rates’ has no theoretical or empirical basis.

• By mid- or late 2021 the pandemic should be under control, and a big bounce-back in financial markets, and in aggregate demand and output, is to be envisaged. The extremely high growth rates of money now being seen – often into the double digits at an annual percentage rate – will instigate an inflationary boom. The scale of the boom will be conditioned by the speed of money growth in the rest of 2020 and in early 2021. Money growth in the USA has reached the highest-ever levels in peacetime, suggesting that consumer inflation may move into double digits at some point in the next two or three years.

• Central banks seem heedless of the inflation risks inherent in monetary financing of the much-enlarged government deficits. Following the so-called ‘New Keynesian Model’ consensus, their economists ignore changes in the quantity of money. Too many of these economists believe that monetary policy is defined exclusively by interest rates, with a narrow focus on the central bank policy rate, long-term interest rates and the yield curve. The quantity theory of money today provides – as it always has done – a theoretical framework which relates trends in money growth to changes in inflation and nominal GDP over the medium and long term. A condition for the return of inflation to current target levels is that the rate of money growth is reduced back towards annual rates of increase of about 6 per cent or less.

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Invite: Professors Geoffrey Wood and Tim Congdon on monetary policy and central banking

Within the launch event of the new MSc in Money, Banking and Central Banking (hosted by the Institute of Economic Affairs in London, 13th March, 12:00-14:00), I will be delighted to introduce two of the teaching staff of the programme, Professors Tim Congdon and Geoffrey Wood, who will be discussing the major topics covered in the programme: such as policies aimed at achieving price stability and financial stability, as well as the current debates on alternative central banks’ strategies and the effects of tighter bank regulation in a post-crisis era. A key question is to assess whether central banks should shrink their balance sheets and, if so, the strategy to do it so economic recovery is not harmed by a shortage in the amount of money. Ins this regard, the US Fed’s Quantitative Tightening policy in recent months will be discussed (see a more detailed analysis here: http://www.mv-pt.org/monthly-monetary-update) along with other alternatives.

This is a new MSc focused on how money is created in modern economies and on how changes in the amount of money affect prices (all prices, consumer and asset prices!) as well as income along the cycle. In addition emphasis is given to the functions, operations and monetary policy strategies of major central banks, so we can understand better the way monetary policy makers actually make a decision. Surprisingly enough, this very classical approach to money and central banking has become quite distinct and unique,  since monetary analysis has been labelled as ‘out-fashioned’ and has somehow been disregarded in the last two decades. The MSc is offered by the University of Buckingham and you can find more on the programme and how to apply here: https://www.buckingham.ac.uk/humanities/msc/money-banking .

Places for the launch event are still available. Should you want to attend RSVP to enquiries@mv-pt.org or call Gail Grimston on 01280 827524. For those who will not be able to make it we will be recording the presentation and the debate and upload it on the Institute of International Monetary Research‘s website (http://www.mv-pt.org/index).

All welcome!

Juan Castaneda

 

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Intended ‘Quantitative Tightening’ by the Fed?

Broad money growth (M3, Shadow Government Statistics) in the US keeps on decelerating since the end of 2015. As reported in the latest Monthly Monetary Update (Institute of International Monetary Research, IIMR), ‘In the final quarter of 2016 US M3 grew at an annualised rate of 2.2%. This follows on from a mere 0.9% in the three months to November, the slowest annualised quarterly growth rate in over five years. 2016 ends with US broad money growing at an annual rate of 4.0%, which is respectable, but down on 2015’s figure of 4.3%. In mid- 2016, the figure was 4.5%. The subsequent slowdown in broad money growth has been primarily caused by “quantitative tightening” ‘.

 

 

 

 

 

 

 

 

Source: January Money Update, IIMR

 

What is ‘Quantitative Tightening’? As stated in the IIMR’s January money update cited above ‘ (…) “quantitative tightening” (i.e., the reversal of quantitative easing) when it allows its stock of asset-backed securities to run off at maturity. The Fed can use proceeds from the maturing ABSs to reduce its cash reserve liabilities to the banks rather than to finance new, offsetting purchases of securities.’ (See the January Monetary Update, IIMR). What we do not know yet is whether the Fed has intentionally pursued such a monetary contractive policy, or rather it is just the (indeed surprisingly unnoticed) consequence of the fall securities in its balance sheet when they reach maturity. As far as I know the Fed has not made a public policy announcement in this regard nor committed to such policy.

Why does this matter? Well it does matter when the medium to the long term correlation between money growth and nominal income is acknowledged. Of course it is not a mechanical or a one-to-one correlation,  and indeed time lags should be taken into account; anyhow in an environment where the demand of money is fairly stable, changes in the rate of growth of money do translate into changes in nominal income. Table below shows such empirical relation in the US in the last five decades:

 

 

 

 

 

 

Source: January Money Update, IIMR

 

Thus should this weakening in money growth in the US continue in the next quarters it will most likely have an impact on economic growth forecasts. This is subject to several caveats though; the new US administration has already announced a profound change in bank regulation which may well ease the pressure put in the midst of the Global Financial Crisis on small and medium size banks particularly to expand their balance sheets. If this materialises in the near future, the creation of more bank deposits in the economy could offset the monetary contractive policy followed by the Fed in the last few months, intentionally or not.

 

Juan Castañeda

 

 

 

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They did it again: The Fed’s role in the Great Contraction of 2008

This was the title of George Selgin (CFMA, Cato) talk at the Institute of International Monetary Research (IIMR) and the Institute of Economic Affairs (IEA) seminar, ‘Quantitative Easing. Triumph or Folly?’ (3rd Nov. 2016). The title of course evokes Ben Bernanke‘s words at the conference held in 2002 to honour Milton Friedman for his 90th birthday; in his speech Bernanke ended with some words that have resonated everywhere in the midst and the aftermath of the Global Financial Crisis in 2007-09: ‘Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.‘ True, banks’ deposits have not contracted (as it did happened in the early 1930’s) around 30% in the recent crisis, but broad monetary growth (M2) plummeted in 2009 and did have a subsequent impact in the extension, amplitude and the severity of the crisis.

The 1930’s crisis is the historical precedent used by George Selgin to judge the Fed’s response to the two major financial crises occurred since the establishment of the US Fed in 1913; the Great Depression and the Global Financial Crisis. Selgin resorts to well-established monetary theory to recommend an early intervention in monetary markets in case of a banking crisis occurs in order to prevent the payment system and financial markets from falling. And he does so by using Walter Bagehot‘s well-known criteria for central banks to act effectively as the lenders of last resort in a monetary system where the reserves are held by a single bank: (1) the central bank must act promptly and provide loans to illiquid but solvent banks with no limit (2) against collateral (assets that would have been used in normal times) and (3) at a penalty rate; that is an interest rate higher than the normal or policy rate.

Did the Fed abide by those criteria?

As you can surely tell by the title of his talk, Selgin is very critical with the lack of an effective response of the Fed in 2008, which ended up in a drastic fall in monetary growth in the economy in 2009 (see the rate of growth of US M2 since 2007 here). Normally banks’ deposits at the central bank are a sort of a restriction that constraint the potential expansion of their balance sheets. The Fed’s policy of increasing the remuneration US banks’ deposits (or excess reserves) in the midst of the crisis (at a time where there were not many profitable investments options for banks) turned those deposits at the Fed as an asset. In this new policy scenario US banks comfortably sat on a vast amount of cash at the Fed, and did get a profit for doing so; this indeed discouraged them from channelling the money lent out by the Fed to the economy and resulted in an ineffective threefold expansion in the US monetary base. This recent example helps to explain the lack of a mechanical connection between expansions in the monetary base and those in  broader measures of money (such as M2, which hardly grew, if at all, at the time).

Watch out George Selgin’s video with his talk in full here for further details. In a nutshell, according to Selgin it was a combination of bad policy measures which caused the Great Contraction and not an inevitable policy outcome. Enjoy the talk!

Juan Castañeda

 

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‘QE, triumph or folly?’

The Institute of International Monetary Research (IIMR, affiliated with the University of Buckingham) is holding an international conference on the assessment of Quantitative Easing (QE) in the US, UK, Eurozone and Japan on the 3rd of November (London). In the last few years a return to a more conventional set of monetary policies has been widely heralded, and in particular the return to a monetary policy rule focused on monetary stability and the stability of the overall economy over the long term (see the excellent conference organised by CATO and the Mercatus Centre  (George Mason University, US) on this very question just few weeks ago); but we believe the first priority at the moment is to analyse and clarify the impact of QE on financial markets and the broader economy. Amongst others, the following questions will be discussed: Has QE been instrumental in preventing another Great Depression? If QE is meant to boost asset prices, why has inflation generally been so low in recent years? Has QE increased inequality? Has QE been able to expand effectively broad money growth? Should QE programmes be extended at all? These are all vital questions we will address at the conference.

The conference is by invitation only and there are still (very few) places available, so please send an email to Gail Grimston at gail.grimston@buckingham.ac.uk should you wish to attend. It will be held on Thursday 3rd November 2016, in collaboration with Institute of Economic Affairs (IEA), at the IEA headquarters in London. You will be able to find a programme with all the topics and the speakers here  As you will see we are delighted to have an excellent panel of experts on this field from the US, continental Europe and the UK. There will be of course very well-known academics but also practitioners as well as central bank economists. In particular economists such as George Selgin (CATO), Kevin Dowd (Durham University), Christopher Neely (Federal Reserve Bank of St. Louis), Ryland Thomas (Bank of England) or Tim Congdon (IIMR, University of Buckingham) amongst many other very distinguished  economists will be giving a talk at the conference, which provides a unique opportunity to analyse in detail the effects and the effectiveness of QE in the most developed economies.

For your information you can also follow the conference live/streaming; please visit the IIMR website this week for further details on how to follow it remotely on the day. In addition the presentations (but not the discussion) will be filmed and published on our website later on. Drop us an email (enquiries@mv-pt.org) should you want to be updated on the Institute’s agenda and latest news.

Thank you,

Juan Castaneda

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A plea for a more neutral monetary policy rule: the ‘productivity norm’

In a series of posts on the assessment of the bias of the US Fed prior to the Global Financial Crisis published on Alt-M, the blog of the recently established Center for Money and Financial Alternatives at the Cato Institute, David Beckworth just published a post with a very clear analysis of the inflationary bias of the Fed before 2008, based on an excellent paper written along with George Selgin and Berrak Bahadir in the Journal of Policy Modelling (those interested in monetary policy rules cannot miss it!).

The publication of both these posts and the academic article couldn’t be more timely. Surprisingly enough, monetary economists still disagree on the stance of monetary policy (not just in the US but elsewhere) before the outbreak of the Global Financial Crisis; this proves that we, economists, are not even that good at what we were supposed to do well, that is, the ‘prediction’ of the past. Leaving the academic interest of the subject aside, this is a policy question of major concern for all, should we want to contribute to the running of more sound, and more monetary-stability-oriented, monetary policy rules in the years to come. Now there are very good academics suggesting the way to exit QE and to move forward towards a more ‘normal’ monetary environment, and it is thus the perfect time to make the case for a different type of policy rules, those compatible with the fall of prices in a growing economy.

As I wrote as a comment on a recent George Selgin’s entry to this blog, the productivity rule ‘certainly provides solid theoretical basis to support the running of a different type of monetary policy rules; indeed different to the (CPI) inflation stabilising rules applied by all and sundry before 2008, which contributed to the recent crisis as well as to the instability generated in markets in the last years. It is time to apply less active and less inflationary monetary rules, those that allow the price level to reflect changes in productivity during expansions. Rather than focusing on price stability (actually it is most often ‘inflation stability’) we should be focusing on rules that better preserve monetary and financial stability on longer term basis; and the productivity norm is a good example of the latter. They are not going to be the cure for all problems but at least they will not be adding monetary disturbances on top of other (real-side) disturbances and shocks affecting the economy. And this will help agents form their expectations and make their plans.‘

For those unfamiliar with this literature, David Beckworth’s post provides the explanation for why (market or Fed’s) interest rates should be increased whenever productivity raises, so that the market interest rate runs in parallel with the natural interest rate, as Wicksell put it a century ago. Since then, this has been taken as the condition to keep monetary equilibrium in the economy (or at least, to put it more modestly and accurately, to avoid at least major disequilibria in the markets) and thus to  prevent from the excess of money creation that so often has contributed to monetary and financial crises in the past as well as to the succession of the so-called boom and bust business cycles. Quoting Beckworth’s words from his recent post, ‘Was monetary policy loose during the last housing boom?’:

‘Note that the rise in the labor force and productivity growth rates both raised the expected return to capital. The faster productivity growth also implied higher expected household incomes. These developments, in turn, should have lead to less saving and more borrowing by firms and households and put upward pressure on the natural interest rate. Interest rates, in short, should have been rising given these large positive supply shocks during this time.‘

And guess what the Fed did during those years of increase in productivity? Focused much more on (a falling) CPI rate of inflation in a growing economy (which shouldn’t be surprising at all), its policy rule didn’t recommend a change in the Fed’s nominal interest rates (at the very best) and later on it kept on cutting them down for years to avoid deflation by all means. It is well time to put the debate on policy rules on the agenda so we dot repeat the same mistakes in the future.

Juan Castaneda

PS. To be fair and fully transparent, let me declare myself any possible conflict of interest (if at all): I am a lecturer at the University of Buckingham and yes, I am a visiting research scholar at Cato (during the spring 2015).

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