March 28, 2024
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The big myth about money and inflation

The growth of the money supply itself does not affect inflation. This is a myth, and the markets have already learned this. However, simultaneousmonetary and fiscal expansion is another matter entirely, and it is likely that markets have yet to grasp this.

I am doing forecasting.This is a difficult and thankless task. But it also teaches modesty like almost no other activity. The most unexpected things can happen. Your forecast may turn out to be wrong due to simple "bad luck" (if a pandemic happens, for example). Another type of predictive error occurs when using a flawed framework. And this is what is so interesting about inflation and its relationship to dynamic monetary processes. Almost the entire profession was mistaken on this score. Not because some unexpected event happened. No, it's just that we were guided by the wrong framework. There is no strong direct relationship between money supply growth and inflation. This is the lesson of the last 10–20 years. We've had plenty of examples of monetary expansion, but there hasn't been any inflation worth mentioning in any of the world's major economies. And the markets have firmly learned this lesson.

The question is, is there a change nowregime to one in which monetary and fiscal policies are much more coordinated and, in combination, can actually affect inflation. If so, the markets will again have to learn a thing or two.

The myth of the simple link between the monetary base and inflation

It is worth citing a few examples of "religion" according to which there is a simple connection between the growth of the money supply and inflation.

First, in the midst of the global financial crisisthere was a fierce debate about the inflationary implications of the Fed's "reckless" monetary expansion, and many were then on the side of this inflationary religion.

Arthur Laffer is a good example of this.He was and remains a popular American economist, also known for the so-called Laffer curve (mentioned in many textbooks on economics). Below is a screenshot of his Mid-2009 Wall Street Journal article. In the article, he confidently states that inflation is about to spiral out of control as a result of over-easing of monetary policy.

Second, I remember the graduate exam.financial analyst (CFA), which I took, I think, in 2002. The exam questions are "secret" and therefore not easy to Google. But there was also a multiple choice question about what happens to inflation when the money supply expands. As if there was a simple "mathematical" answer to it.

Finally, you can just google something like“Money supply and inflation” - in Russian or in English. Almost all of the first 10-20 search results will claim that there is a simple connection between the two concepts. Once a myth is firmly rooted in thinking (and teaching), it can be very difficult to get rid of it. The economy also has its own "fake news".

In fact, there is no simple connection between money and inflation.

First, Japan has always been an instructive example in this regard, as this country has tended to be at the forefront of monetary experimentation over the past twenty-odd years.

The graphs below showdetailed overview of monetary expansion in Japan (source). Over the past decade or so, we have seen a sharp easing of monetary policy - within the framework of Abenomics - starting in 2013, and further easing in response to the economic shock caused by the 2020 COVID pandemic and the response to it.

The main feature is that the BankJapan has accumulated 500 trillion yen of government bonds in the region, while the amount of bank reserves (the main component of M0) has grown sharply (a typical feature of quantitative easing through an asset swap). In particular, the monetary base during this period grew by more than 400%, while inflation remains well below the 2% target of the Bank of Japan. Monetary policy failed to keep pace with inflation, even during a period of incredibly aggressive expansion, which was an obvious goal and reality under the abenomics of Haruhiko Kuroda and the Bank of Japan.

Secondly, we can take a look at the data on morea wide cross section of economies. The figure below shows the growth rate over 8 years from the beginning of the millennium to the end of 2007 (left) compared to the period from the end of 2007 to September 2020 (right).

Before the global financial crisisthe relationship between the growth of the monetary base and inflation was not violated. With the exception of China, where growth in the monetary base was accelerated by the accumulation of foreign exchange reserves by the People's Bank of China, the growth in the monetary base was comparable to the rise in consumer prices over the same period.

If we look at the period from the end of 2007(right), then, again, with the exception of China, all countries showed a sharp acceleration in the growth of the monetary base. The simple average of base monetary growth (excluding China) increased to 15.6 percent (from 5.2 percent before the global financial crisis). Let me remind you that this growth rate must be calculated using the compound interest formula over a period of more than 12 years to obtain the reserves of the monetary base observed in September of last year. And despite this acceleration in the growth of the monetary base, with the exception of China, Japan and the UK, all countries experienceddecelerationinflation.Indeed, the cross-country relationship between base money growth and inflation since the global financial crisis suggests that the greater the base money growth, the lower the resulting inflation, which completely turns old monetary theories on their heads.

Doesn't the monetary base really matter?

While it is clear that there is no simple mechanical connection between the money supply and inflation, I would not argue that there is no connection at all between the two.

Monetary expansion can play a big role in inflation when combined with fiscal expansion.

It can be helpful to look for "stylized facts"on this issue in emerging markets with a more “extreme” history in this area. Below is a summary of the results of a simple regression from an IMF study on this topic (“The Modern Hyperinflation Cycle: Some New Empirical Regularities,” WP / 18/266).

The results obtained show that in theseIn some episodes (driven by a large sample of emerging economies), growth in the monetary base mattered, as did fiscal variables. This is just one study. But it appears to illustrate a key point, as the recent experience of Argentina has shown.

Conclusion

Money printing (quantitative easing) during the period2008–2019 was mainly monetary expansion through an asset swap. The central bank bought assets (bonds) and created bank reserves for the banking system. Simplifying somewhat, we can say that the direct impact on the real side of the economy and on the dynamics of the final (consumer) prices was very insignificant.

This is fundamentally different from the situation where money printing is used to finance government spending or reduce the tax burden (and not just for the purchase of assets).

If the printing of money is connected with the actual formation of demand (through government spending or transfers), then in this case the relationship with inflation is likely to be much stronger.

Here is a simple distinction betweenvarious types of monetary expansion. But for some reason, many overlook it, which leads to the proclamation of dark prophecies on the verge of religious pathos regarding the role of money in the dynamics of inflation.

What really matters in terms ofperspective is whether or not we have now entered the new regime. A new regime in which aggressive money printing and fiscal expansion go hand in hand is a policy of simultaneous fiscal and quantitative easing. This is important, because in such a regime, printing money can really be associated with a real surge in demand, and then it can very much even be part of the process leading to an increase in inflation.

If policymakers decide to take this new path, then it is likely that the markets will have to learn something new again about the relationship between money and inflation.

The end.

 

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