Changing monetary dynamic poses problem for central banks

  • Broad money growth in the ‘inflation-hit west’ is slowing
  • The implication is that inflation will ease, though probably not earlier than H2
  • Central banks face a new dilemma; they still need to tighten policy, but not by too much

Over the turn of the year, broad money growth in the large inflation-hit western economies has slowed. US broad money growth (using Stein Brothers M3 replacement) dropped from above 10% in the period August to November 2021 to 8.5% in the year to January. Three- and six-month annualised growth rates, which provide a better picture of recent trends, are somewhat higher, but are also easing. 

Euro Area M3 growth dropped to a two-year low of 6.4% in the year to January, with the most recent data pointing to a further slowdown. Finally, in the UK, M4x growth fell to 5.4% in January, again a two-year low. Here too, recent data show that broad money growth should ease further in coming months. 

Assuming these trends continue, the outlook for inflation to slow down is improving. However, there are a few caveats:

First, inflation rates will still accelerate over coming months. This will be exacerbated by (primarily) commodity and energy price rises as a consequence of the Russian invasion of Ukraine. That increases the risk of a wage -price spiral in mid-2022, which, if validated by central banks, risks igniting further inflation.

The second factor is that inflation expectations – measured by survey data – remain elevated, both in the EA and in the United States. The difference between them is that in the US, survey data show some easing of price pressures compared with last autumn, whereas in the EA, both selling-price expectations and consumer inflation expectations continue to rise. This may be related to the fact that the Federal Reserve has made it clear that it will move to ‘tighten’ (or, rather, normalise) monetary policy. By contrast, the ECB is still perceived to be behind the curve.

In light of the slowdown in monetary data, should central banks really embark on tightening? On balance, the answer must be yes. Inflation is well above the 2% that is the target in most countries and is likely to remain so for the remainder of 2022. As we have seen over the past week, there are risk factors that can suddenly appear and throw this relatively developments off course again. Moreover, even if inflation were to come down to 2% in due course – and even with slower broad money growth, this is by no means guaranteed – it is difficult to see how this can remain a stable situation as long as real interest rates remain negative. However, it may well be that the amount by which interest rates should rise is less than seemed to be the case some weeks ago.

What about the other risk, namely that inflation not only eventually eases towards target, but actually drops below it again? This is possible, but less likely. Again, monetary data provide a clue. In this case, it is the pick-up in the growth of credit to the non-bank private sector. In theory, broad money and credit should grow at roughly the same rate, since they make up, respectively, the bulk of bank liabilities and assets. In practice, they don’t always follow suit and can, in fact, diverge quite substantially for quite some time. However, in the US and the EA, broad money and credit growth are now approaching each other. In the US, credit grew by 4.8% in the year to January; weekly data show continued healthy growth in February, notably of consumer loans. In the EA, credit growth advanced to 4.6% in January. In both economies, this is the strongest numbers since 2020. (By contrast, UK credit growth remains feeble.) To some extent, borrowing may be picking up because households and companies expect interest rates to rise and want to lock in to current rates before this happens. Nevertheless, the numbers do show the continued revival of consumer demand. Again, this is likely to take some hit of the war-induced price increases become more entrenched. Nevertheless, on balance, both broad money and credit growth are now good.

Overall, therefore, the monetary dynamic in the large western economies seems to be changing and becoming more benign. But, paradoxically, this presents central bank with a new dilemma. A month or two ago, they had ‘merely’ to consider if, when and by how much to tighten monetary policy in the face of accelerating inflation. Normalisation of monetary policy – involving higher policy interest rates and slimmer central bank balance sheets – remains desirable and necessary.  But now they must also consider the danger of overshooting on the upside. 

Gabriel Stein