01/02/2023 This should be an easy one. They printed way too much and
for too long. We all know this, but why didn’t central banks figure it out? Partly because
they ignored a very basic tenet of economics – the growth in the supply of money matters for
inflation dynamics. Milton Friedman famously proclaimed that inflation is ‘always and
everywhere a monetary phenomenon’ — a problem of printing too much money. Every newsletter
writer likes to pull this quote out and this one is no different. But despite its hackneyed
overuse, it was ignored on the grounds that the correlation between money supply and
inflation had broken down in recent years. Austerity and banks’ desire to rebuild capital
meant money growth in the wake of the global financial crisis did not lead to inflation. But
the opposite forces have been work because governments allowed their debts to balloon by
going on a spending spree. Central banks were complicit in funding this debt – effectively
monetizing issuance – in a phase that was similar to the 1940s when the US was funding WW2.
Jay Powell, the Fed chair, didn’t think money growth mattered. Speaking in February 2021, he
said “there was a time when monetary policy aggregates were important determinants of
inflation and that has not been the case for a long time.” He added: “the correlation
between different aggregates [like] M2 and inflation is just very, very low, and you see
that now where inflation is at 1.4% for this year. Inflation dynamics evolve over time, but
they don’t tend to change overnight.” Even as recently as May 2022, Andrew Bailey, the
governor of the Bank of England, stated that “What I reject is the argument that in our
response to Covid, the Bank’s Monetary Policy Committee let demand get out of hand and thus
stoked inflation. The facts simply do not support this.” ‘Not our fault gov’, he may as well
have said. Last year the European Central Bank fessed up that it got its inflation forecasts
wrong. We could all see this for ourselves, but it was nice of them to admit it – only even
then they shirked the money growth question, arguing that the reason for their consistent
errors was “largely due to exceptional developments such as unprecedented energy price
dynamics and supply bottlenecks”. In this entire
paper there is not a single mention of money growth or related terms. How could this
amount of money growth not lead to inflation?
‘The Party told you to reject the
evidence of your eyes and ears. It was their final, most essential command. How could
we all see it and yet be told not to believe our eyes? Thankfully some good folk at the
central banks’ schoolmaster have done some research and told us what we knew to be true. In
a new
bulletin, the Bank for International Settlements (BIS) says that looking at money growth
would have helped to improve post-pandemic inflation forecasts, suggesting that its
information value may have been neglected. Across countries, it says, there is a
statistically and economically significant positive relationship between excess money growth
in 2020 and professional forecasters’ misses of inflation in 2021 and 2022. “Could
incorporating information about money growth have helped to improve the forecasts of
professional economists?” ask the authors of the BIS report. “This is a tougher test because
these forecasts presumably contained all the information available to forecasters when they
were making their projections. The answer appears to be ‘yes’.” The authors of the report
also note that a link can be seen in the recent possible transition from a low to a
high-inflation regime. “An upsurge in money growth preceded the inflation flare-up, and
countries with stronger money growth saw markedly higher inflation,” they write. The US
printed – and we should note it’s not just the Fed here but the US Treasury – something like
$7 trillion in two and a half years. What did they think would happen? Of course, as the
great investor Paul Tudor Jones explained in May 2020 in an important letter
to investors that has guided much of my thinking since then about the Great Monetary
Inflation, monetary expansion alone is not sufficient to generate inflation. In the wake of
the global financial crisis, unending quantitative easing failed to produce inflation as
banks absorbed the increase in money to bolster their liquidity and capital requirements.
This time was always going to be different because of the direct fiscal stimulus that
accompanied the central bank activity. The only comparable growth in M2 compared to real
output growth over a 5-year span were the inflationary periods of the 1970s–80s and the late
1940s. Everyone else could see that printing all that money would likely cause inflation. So
why didn’t Powell and co see it too? In a note to clients on August 26th, 2020 I
wrote the following – 
“I find this idea of AIT
[average inflation targeting] being a better anchor for inflation
expectations problematic. Whilst I don’t pretend to being an economist, regular readers will
be familiar with my view that a sharp bounce back in growth (albeit to a level still
below pre-pandemic potential) combined with unlimited Fed accommodation, a vast increase in
the money supply (if not yet the velocity of money) and a massive fiscal put
is basically inflationary.
The rate of expansion in the monetary base is consistent with past bouts of high
inflation in the 1930s, 1940s and the 1970s.
Whilst post-GFC QE
led to money printing, it was gobbled up by a financial system hungry for capital and
balance sheet repairing. The fiscal stimulus this time makes it a very different
environment.
Layer on top of that the disruption to supply chains and fundamental shift in
deglobalisation trends, and you create conditions suitable for inflation to take hold
. If the Fed also indicates it does not care if inflation overshoots for a time –
indeed is actively encouraging it – there is a risk inflation expectatio
ns become unanchored as they did in the early 1970s, which led to a period of
stagflation
… My concern would be that once you let the inflation genie out of the
bottle it can be hard to put back in without aggressively tightening and likely as
not engineering a recession. Nonetheless, this seems to be the way the Fed is going.”
And all this matters now because shifting from a high inflation regime to a low one is very
difficult. We are on the verge of a “paradigm shift” in the global inflation regime, the BIS
warned last year. “We may be reaching a tipping point, beyond which an inflationary
psychology spreads and becomes entrenched.” In the more recent bulletin, authors Claudio
Borio, Boris Hofmann and Egon Zakrajšek conclude: “Might the neglect of monetary aggregates
have gone too far? In the end, only time will tell.”