The case for higher inflation

  • Over the past two months, broad money growth has surged in key world economies
  • This monetary stimulus, part of the response to the COVID-19 pandemic, will remain in place
  • Sustained double-digit broad money growth is inconsistent with subdued inflation

(It is more than a year since I last published a Comment. The longer the delay, the more embarrassing it becomes to restart writing. However,  my friend John Nugée of Laburnum Consulting has just published a piece called Debt Dynamics, where, among other things, he argues that deflation is is one likely consequence of current developments. I disagree and I thought it important to explain why. I hope you will find of interest.

This may be a once-off or I may return to writing occasional Comments.)

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The case for higher inflation — a rejoinder to John Nugée’s Debt Dynamics

On 3rd May, John Nugée published a piece entitled Debt Dynamics. While I agree with much of what he says, I take issue with his point that inflation will remain subdued. I would argue that, assuming lockdowns are generally lifted by the middle of the year at the latest, inflation will in fact be quite rapid in 2021 and 2022 and well above numbers we have grown used to seeing.

One of John’s key points is where he says “And if the multiple rounds of Quantitative Easing since 2010 (different in style only from monetary financing, not substance) did not produce inflation in the last decade, when the world’s GDP was growing, albeit slowly, we do not think the current level of government borrowing and central bank funding will be inflationary against a backdrop of what is likely to be a prolonged period of depressed demand.”

Milton Friedman famously said: “Inflation, over any sustained period of time, is always and everywhere a monetary phenomenon.” This remains true today. Anyone who takes the trouble to plot inflation against broad money developments over the medium- or long-term can easily see this.  Yes, there are the “long and variable lags” and the relationship is not identical over time or between countries, but it is there. Hence, in order to see if inflation is in the offing, the best leading indicator is to look at monetary developments.

However, central banks broadly speaking no longer look at broad money; in some cases, they don’t even understand it. This coloured their reaction to the Great Recession. With one exception, policies followed after 2008, failed to significantly accelerate broad money growth. The exception was China, where the People’s Bank engineered a massive monetary stimulus, which unsurprisingly was followed by a rapid rise in inflation (from -1.8% in the year to July 2009, to 6.5% in the year to July 2011). Elsewhere, broad money growth weakened in the immediate aftermath of the Great Recession and then picked up to fairly anaemic numbers over the next five years — regardless of whether QE was implemented or not (Table 1). The reason was that QE, while boosting banks’ reserves with their respective central banks, did not, in fact, flow into the ‘real economy’; and this is why inflation remained below target.

USA(Broad Money)EA (M3)China (M2)Japan (M3)UK (M4 until June 2009, then M4x)Australia (Broad Money)Sweden (M3)
200710.611.317.50.21.01.516.3
20089.89.516.60.71.20.89.3
20092.23.026.41.80.30.42.1
2010-3.40.420.82.10.20.71.8
20114.61.515.62.20.10.63.3
20123.83.017.32.20.40.56.6
20134.82.314.82.90.30.52.4
20144.51.912.72.80.40.64.1
Table 1 Broad money growth, average annual change, %

By contrast, in the current situation, broad money growth is exploding in most major economies (Table 2). True, this is as yet early days. We have at most one or two months of monetary data available since governments and central banks began their responses to the COVID-19 pandemic. Yet the numbers are clear, and, assuming that current trends continue for some time, which there is little reason to doubt, the message for inflation is also clear. 

USA (Broad Money)EA (M3)China (M2)Japan (M3)UK (M4 until June 2009, then M4x)Australia (Broad Money)Sweden (M3)
12-month change
Jan 207.55.28.42.10.80.57.4
Feb 207.35.58.82.10.40.37.2
Mar 2010.57.510.12.22.82.712.8
3-month annualised change
Jan 206.42.37.21.76.44.13.5
Feb 206.34.616.91.94.63.20.8
Mar 2020.115.514.92.314.013.730.0
Table 2 Broad money, recent changes,

With the exception of Japan, broad money growth has accelerated in all the economies in the table; and on a three-month annualised basis, a volatile number but a guide to recent trends, the numbers are now in the double digits.

Credit growth has not picked up quite as much. But this is not surprising. Nor is it particularly important. While money and credit broadly speaking are two sides of the same coin (the liabilities and the assets of the banking system, respectively), there is one crucial difference between them. Credit — borrowing — has to be accepted, i.e., borrowers have to want to take on more debt. By contrast, accepting money doesn’t bring with it any obligation.

This being said, there is one interesting and relevant set of data. The Federal Reserve publishes weekly money and credit data. The latest numbers go up to late April and show a similar surge.On a thirteen-week (i.e., three-month) annualised basis, loans and leases in bank credit grew by between 4 and 6% for the first ten weeks of the year. In the most recent four weeks, the number is above 30%. Commercial & industrial (c&i) loans fell on the same basis from early October 2019 to the end of February. But in each of the last four weeks available, they have risen by a thirteen-week annualised rate of more than 100%, with the week of 20th April at 162%! The previously highest number recorded in this series was in 1960, when it was just over 41%. 

There is little reason to expect monetary growth to slow for most of the rest of the year (although the US c&i loans data almost certainly will ease). In fact, governments are likely to wish to keep both the monetary and the fiscal stimulus in place for rather longer than that, particularly if we see recurrent waves of COVID-19. And this is the case for higher inflation. Sustained double-digit broad money growth is historically not consistent with ultra-low inflation, let alone with deflation. 

Add to this that both central banks and governments would like to see higher inflation: central banks because they still hope to reach their inflation targets, governments because inflation is the least painful way to deal with the debt they have taken on. Where John in his article writes that he expects deflation to be the order of the day over the next 3-6 months, I would say that over the course of 2021 and 2022, I would be surprised to se inflation below the 2% that is the target in most inflation-targeting economies; and I would not be surprised to see it reaching both 3%, 4% and possibly as much as 5% in quite a few of them.

Gabriel Stein

gabriel@gabrielstein.com