What does the collapsing monetary growth mean for inflation?

Former Bank of England Governor Mervyn King argued recently that monetary data shows that the BoE was too slow to hike rates and now may be too slow to cut them.

Major central banks seem set to hike rates again, with 25-bps hikes seen in the US on Wednesday, from the ECB on Thursday, and in the UK early next month. Former Bank of England Governor Mervyn King argued recently that monetary data shows that the BoE was too slow to hike rates and now may be too slow to cut them. If he is right about the UK, it’s likely to be the same in the US and Eurozone as well. But is he right?

Citing surging monetary data as a harbinger of higher inflation seems like a bit of a broken-clock sort of forecast in the Standard Bank’s view. A broken clock is right twice a day, and it could be argued that die-hard monetarists are right once in a blue moon as well. Warnings that the era of zero policy rates and quantitative easing would bring rising inflation were wrong for many, many years before they proved right. But were they proven right?

The Standard Bank’s view has always been that fast monetary growth has the capacity to lift inflation, but what’s crucial is the supply of goods, services, and assets that sits on the other side of the equation. For instance, strong monetary growth need not lift inflation in goods, services, or asset prices if the supply of these is very responsive (what economists call elastic). It seems as if the supply of two of these, goods and services, was very elastic in the period between the global financial crisis (GFC) and COVID-19, largely because massive new supply was coming on stream, primarily from China.

In fact, this supply was so ample that it overwhelmed any monetary overhang, and we saw excessive disinflation, even deflation, not inflation. The situation was not the same for assets. China, for instance, was increasing the goods and services available on a global level, but its relatively closed capital account meant that it was not supplying large amounts of assets to the rest of the world.

On top of this, major central banks were reducing the availability of these assets (bonds) through quantitative easing. The result was that the inflation between the GFC and COVID was in assets, not goods and services. Hence, the argument that fast monetary growth would lead to massive goods and service inflation seemed wrong. Fast monetary growth is a necessary, but not sufficient, condition for higher inflation. Of course, the ‘sufficient’ condition for higher inflation was generated by the pandemic and the energy supply curbs from Russia’s invasion of Ukraine. These restricted the supply of goods, largely via supply chain disruptions and labor shortages in developed nations.

Once this ‘sufficient’ condition was met, and with central banks redoubling their efforts to lift the ‘necessary’ component—fast monetary growth—goods and services prices surged. We could go further and say that the inflation was ‘transferred’ from asset prices to goods and service prices.

And so, we come back to today, where money supply growth is collapsing. If surging monetary growth was a necessary but not sufficient part of the inflationary period, will collapsing monetary growth now prove wide of the mark in predicting much lower inflation in goods and services? Here, the ‘sufficiency’ condition for much lower inflation seems to be dependent on a big rebound in the supply of goods and services; if these are still compromised, falling monetary growth may not bring significant disinflation.

As far as we can see, evidence suggests that supply chain issues have disappeared, but the labor shortage issue still lingers for many. Things will loosen up here, and, at that point, the ‘broken clock’ prediction that collapsing monetary growth will mean much lower inflation will prove accurate. We can’t say that this will happen soon, but it does seem to be coming.

As a result, the likes of Mervyn King may well be prescient in their claim that the BoE risks holding on to high (or even higher) policy rates for far too long. But while this seems a risk now, the Standard Bank thinks that central banks will actually flick the rate switch pretty quickly and aggressively next year—more aggressively than the market is pricing—but perhaps not as determinedly as King would like to see.