Four years ago, at the worst point in the Great Recession, several leading American economic gurus said that the Fed’s easy monetary policy risked higher inflation which might imperil the recovery. In some of the early commentaries from International Monetary Research (in the spring and summer of 2009), I argued that these gurus – who included the revered Alan Greenspan and Martin Feldstein, a prominent adviser to President Reagan – were seeing ‘ghosts’. Also at that time Liam Halligan of Prosperity Capital Management used his column in The Sunday Telegraph to attack ‘quantitative easing’ (i.e., the large-scale creation of money by the state) as aggressive ‘money printing’ which would lead to a sharp rise in inflation. In a letter to the Financial Times published on 19th June, I showed that the inflation jeremiahs had been wrong. The last five complete years (i.e., the five years to 2012) saw the lowest increases in nominal GDP in all the G7 economies since the deflationary 1930s. The jeremiahs of 2009 made a serious analytical mistake. They thought that inflation was caused by excessive growth of the monetary base, not of the quantity of money broadly-defined to include all bank deposits. In future economic commentators should pay more attention to the quantity of money as such and de-emphasize the monetary base by itself.
In my weekly e-mail of 27th April I emphasized that, as in the USA’s Great Depression of the 1930s, its Great Recession of the last few years has been accompanied by a collapse in the growth of the quantity of money. As that note observed, the annual growth rate of M3 – which peaked in the high teens in late 2008 – had crashed to a negative value less than two years later. Last summer M3 was still dropping. The weakness in money growth had been associated for some quarters with a disappointingly sluggish recovery. In early November 2010 Fed chairman, Ben Bernanke, announced a ‘QE2’ programme. Heavy purchases of long-dated US Treasuries (with five or more years to redemption), amounting to $600b., were meant to boost the US economy. (Bernanke – best known in academic circles for his work on ‘the credit channel’ – did mention in Congressional testimony that the asset purchases would increase the quantity of money. However, a fair comment is that, like the institution he represents, he is rather puzzled by the mechanisms by which changes in the quantity of money affect economic activity.) This weekly e-mail updates the analysis in late April. The central points are twofold. First, the last few months have seen a welcome return to positive growth, if at a low rate, in broad money on the M3 measure. (And, indeed, macroeconomic conditions haven’t been too bad, although they have hardly been brilliant.) Second, the upturn in M3 growth has been due – entirely – to QE2. US banks’ cash assets have soared, reflecting the Fed’s operations. But their risk assets have been static since the start of QE2, with the need to comply with higher capital/asset ratio regulations undoubtedly being the main restrictive influence. The further message is that – unless banks’ propensity to acquire risk assets strengthens after the end of June – US broad money will again stagnate. That will continue to hold back the recovery.
Consumer price inflation in the UK, at an annual rate, is likely to be in the 4% - 5% area for some months in 2011. Is inflation now headed inexorably on an upward path? Or will it drop back towards the 2% target or less in 2012 at the current monetary policy settings? Companies are at present grappling with large increases in the price of raw materials and energy. These increases – plus the rise in value added tax needed to reduce the budget deficit – are the dominant influences, in a cost accounting sense, on the upturn in inflation. Usually changes in unit wage costs are far more important than changes in raw material prices in determining inflation outturns. A reassuring message of recent data is that wage rises remain subdued, with high unemployment constraining workers’ ability to demand higher pay settlements. Further, the fundamental driver of inflation is the rate of money growth relative to the trend rate of increase in output, although – it has to be said – changes in the desired ratio of money to income complicate the answer. My main points here are twofold. First, the current rate of increase in the quantity of money, on an underlying M4 basis, argues strongly against any acceleration in inflation over the medium term. Secondly, officialdom has fallen into the habit of seeing movements in the exchange rate as being ‘exogenous’, so that they are not related to (or blamed upon) official policy. This is a mistake. In the long run the exchange rate is the price between two monies, and the price is affected by the strength of the demand to hold money in different countries relative to the quantities of money in existence in those countries. A country with a rapidly ballooning quantity of money is likely to experience currency depreciation and inflation. British inflation is still being pushed up by the aftershocks of the big devaluation in late 2008, which in turn should be interpreted as one result of the unduly high money growth in the previous two to three years.