All the main Central banks have the task of running monetary policy in their respective areas. The Fed, the Bank of England, the European Central Bank and the Bank of Japan all have a prime target to keep inflation to around 2%. The People’s Bank of China assists the government with its economic growth target and aims to keep money growth in line with economic growth. They are the only one of the major Central banks with any kind of money target.
In the days of the Bundesbank, prior to the launch of the Euro, Germany based monetary policy on controlling the growth of money and was successful at keeping inflation down for a long period. The policy was finally disrupted by the political decision to merge East Germany with West Germany with a very generous offer to every holder of Ostmarks to have the same number of West German Marks in exchange. This was followed by the abolition of the currency and replacement by the Euro. The Euro was born into a new world of central banking theory based on inflation targets and study of capacity utilisation to try to judge whether there was a danger of overheating. After the western banking crash of 2008 this approach had a good run for a decade with low inflation. It was a time of growing globalisation with plenty of good value Asian goods to keep prices down. Commercial banks were cautious as regulators made them increase balance sheet strength, which made them more prudent over lending money.
Central banks get it wrong
Today, there are questions to answer about how most of the Central banks have got it wrong at the same time. Inflation is at more than four times the target in the USA, the Euro area and UK. We also need to ask why Japan and China still have inflation of around 2%, even though they are big importers of energy which has shot up in price and is being blamed for much of the inflation elsewhere.
This century, it became unacceptable for western Central banks to follow monetarist explanations of economies, as they all turned their backs on the old Bundesbank model. Between 2008 and 2020 most Central banks did keep money growth under reasonable control as a result of other decisions they were taking. Japan was pursuing the then unorthodox policy of creating additional yen in the Central bank and keeping interest rates around zero, but it was not causing a general expansion of money supply and did not cause any general inflation, other than pushing up bond prices. The M3 measure of money growth was at an index level of 113 in Japan, 127 in the UK, 132 in the USA and 125 in the Euro area just before the pandemic, up from a base of 100 in 2015. Money growth had been modest.
M3 supply for major economies
Covid led to growth in money supply
Policy changed dramatically for the Fed, ECB and Bank of England in March 2020 in response to the pandemic. All three, led by the USA, decided on a major injection of newly-created money into financial markets to prevent an economic collapse as lockdown curtailed activity and cash flows for many businesses and individuals.
Is it a coincidence that Japan and China, which did not follow the policy, have 2% inflation today and the others have a problem?
The US saw the biggest surge with growth in the money supply, increasing by 24% in the year to March 2021. The ECB and the Bank of England, meanwhile, grew theirs at around 10%. Japan was lower at 7.9% and Chinese money growth hardly changed from its steady previous trend. The immediate monetary response was very necessary and prevented a far worse outcome. However, did they carry on with their extraordinary approach for longer than they should? By March 2022 US money growth was up 36% over two years, and in European it was 17%. Is it a coincidence that Japan and China, which did not follow the policy, have 2% inflation today and the others have a problem?
Critics of the monetarist approach rightly point out that what matters for growth and inflation is not simply the amount of money around, but also the use made of it. A Central Bank could allow the amount of money to double, but if people use it half as often there will not be a price impact. If, however, what economists call the ‘velocity’ of the circulation of money does not fall when you create more of it, then more money chasing the same amount of goods will drive up prices. If you give everyone more money than before and they try to spend it that must be inflationary. Anti-monetarists also point out that more money can result from the inflation and query any predictive power for money aggregates. They remind us that the inflation index in Japan and the use of controlled prices in China make other explanations of the apparent Asian success possible.
Lower inflation to come?
Over the last year the Fed carried on printing until the end of March, the UK stopped money creation last December and the European Central Bank continues right up to the end of June this year. Money growth has come down from the highs of 2020 but is still at 8% in the USA, 6% in the Euro area and 5.6% in the UK. Monetarists, therefore, think inflation should come down from the highs into next year. The main Central banks are also forecasting lower inflation next year based on their models of slowing economic activity. The bad news, particularly for the USA, is inflation will remain well above the 2% target pending the tougher action that is now appearing. As Central banks review what went wrong, we suspect they will need to keep an eye on money and credit growth in their economies as they used to do, without yet wishing to change the type of targets they use to drive policy. It remains the case that if a country gets high inflation they will create more money, as Venezuela with 500% money growth and Argentina with 46% remind us.
Meanwhile, there are fears about how widespread the inflationary forces are and how long they will linger, especially in the US, which will keep the Fed hawkish a bit longer and markets worried.
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Central banks, money and too much inflation
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