If you don’t think money matters, you will raise interest rates

  • Ben Bernanke is due to mark the Bank of England’s ‘course work’ – he should fail it, but won’t
  • EA money supply is falling, but the ECB seems not to care
  • If you ignore money developments, you should keep tightening policy; but not if you think money is important

Ben Bernanke, former Chair of the Board of Governors of the Federal Reserve, is set to start reviewing the Bank of England’s recent monetary policy. Since I am currently marking essays by my Macroeconomic Theory students at the University of Buckingham, I sympathise. By rights, Bernanke should give the BoE a failing grade. The Bank failed to see inflation coming, and failed to understand how high it would get or how long it would last. However, he almost certainly won’t. Why not? Because the reason for the Bank’s failure to anticipate high and sustained inflation from 2021 onwards was due to its wilful ignorance of monetary developments; and this is something with which Ben Bernanke agrees. After all, it was during his tenure that the Fed decided to stop publishing data for M3 in the US.

Meanwhile, Andrew Bailey, Governor of the Bank of England is now on the record as saying that interest rates have peaked and that inflation will soon come down sharply (The Times, 7th September). However, this is the same Andrew Bailey who previously said that markets were wrong when they expected Bank Rate to reach 5.2% (reached on 3rd August this year), and who, like his predecessor in office, Mark Carney, has gotten almost every forecast wrong. As it happens, Mr Bailey is almost certainly right on inflation, certainly so judging by the monetary data. M4x did not grow at all in the year to July and has been growing at less than 5% since November 2022. But if he ignores monetary data, there is still every reason to raise interest rates further. After all, Bank Rate is still negative in real terms; and at 6.4%, inflation remains well above the 2% target. So the likelihood is that the Bank will still raise Bank Rate in coming months.

There is a similar situation in the Euro Area. There, the stock of broad money (M3) fell by 0.5% in July. Even newspapers that normally ignore money developments remarked on it. In addition to the monthly fall, M3 has been falling on a twelve-month basis throughout 2023 and is now 1.5% below its peak in September 2022. 

Counterparts analysis shows that the monetary weakness is broadly based. Credit to the non-bank private sector is still growing, but the 1.2% growth rate in the year to July was the weakest since 2016; while credit to the public sector has contracted since late 2021. There is also a small drag on money growth from banks rebuilding their capital. As interest rates rise, there is little prospect of a reversal of credit trends, and hence also not of a resurgence of broad money growth.

For a monetarist, the message is clear: the headline rate of inflation – which has come down to 5.1% in the year to August, from 10.6% in October 2022 – will continue to fall. This will not necessarily be a smooth process: in August itself, headline inflation was 0.6%, which, if sustained for an entire year, would mean a rate of 7.4%. Moreover, core inflation has only come down from 5.6% earlier in 2023 to 5.1% by August.

However, the focus on core inflation is really only valid if core inflation somehow is the ‘true’ number and if headline inflation ultimately converges on the core rate. As Dan Thornton, former Vice-President of the Federal Reserve Bank of St Louis has shown, this is not the case.

Cross-checking the monetary data with business and consumer surveys confirms the likelihood of much lower inflation. The manufacturing sector inflation outlook index dropped below 20 – the level historically associated with the ECB’s 2% inflation target – in March this year and has been below 10 since May. The consumer inflation expectations balance has also been in single digits since May. Current levels are those historically consistent with inflation around 1%.

That may well be too optimistic and the relationship is not 100% certain. However, the combination of the survey data and the money numbers clearly point to inflation coming down, probably quite rapidly, over the next 6-12 months.

But money blindness is not only a UK phenomenon. In an interview (with The Currency, 5th September 2023), the ECB Chief Economist Philip Lane discusses the outlook and causes for inflation and almost manages to avoid mentioning the word money at all.

And, of course, like in the UK, the ECB real policy rate is negative and inflation is well above target.

Add to this two other factors which are likely to influence central bankers:

One is the awareness of much credibility lost in failing to foresee higher inflation and – when it was becoming obvious – how long it could last. To stop tightening policy before it is clear that inflation is well and truly contained at, or at least near the 2% target, could risk another bout of price rises and further erode tattered central bank credibility. (In fact, it seems likely that, on a 5-to-10-year horizon, policy will be aimed at letting inflation overshoot somewhat, rather than risk any undershooting. This is, of course already the intention of the Federal Reserve’s policy of Average Inflation Targeting.)

Second, a desire to get interest rates back to ‘normal’ levels, ensuring scope for monetary policy to ease in the future.

And so the ECB is also almost certain to continue to raise interest rates over the remainder of 2023.

The world economy has shown itself amazingly resilient in the post-covid era, notably by coasting along in spite of continued higher interest rates. However, whether the EA and the UK will manage to avoid a central-bank induced recession in 2024 is now becoming much more questionable.

Gabriel Stein