John Greenwood: Inflation is a monetary phenomenon so don’t ignore the rapid rise in money growth

At our recent webinar on inflation, John Greenwood, Arnab Das and David Millar gave an update on their latest thoughts on the subject. With markets showing increasing signs of anxiety that inflation is poised to move higher, possibly into unfamiliar territory, the debate was certainly timely and topical. The uncertain outlook was reflected in a broad range of views being offered by our speakers. Although a lot of ground was covered, the full schedule meant that John and Arnab were not given the opportunity to answer all the questions. A selection of these additional questions are answered by John Greenwood below.     

John Greenwood believes we could be on the verge of breaking out of the low inflation, low interest rate environment which financial markets have become accustomed to for many years. Unlike the post-global financial crisis recovery in 2008/09, this time we are experiencing double-digit rates of money growth in the US as well as in Europe, Canada and Australia. For the US, this could see CPI inflation reach as high as 5% in 2022/23.

1. Is inflation the medicine needed by governments at these high debt levels?

No. If the government debt/nominal GDP ratio has increased by 20-30 percentage points (as it has following the Covid-19 pandemic) and the government or central bank engineers a period of inflation, it is true that the real value of the debt in the numerator would be eroded, but the nominal GDP in the denominator would also be eroded in real terms by the same amount.

In practice governments never repay debt.

What normally happens - and is likely to happen this time - is that governments will gradually reduce their annual budget deficits to 2-3% of GDP or less.

That would mean that they are only adding to debt by 2-3% p.a.

If at the same time the nominal GDP grows at 4-5% p.a. (2% real growth and 2-3% inflation), then the numerator will be growing more slowly than the denominator, so gradually over time the ratio of debt to GDP will decline.

2. Why would governments want low inflation given the increased amount of debt? This assumes that central bank governors will essentially be silenced (i.e. less independent).

The answer to this question is basically the same as the answer to the previous question, except that I need to add a word or two about the independence of central banks.

In the 1970s and 1980s inflation was a persistent problem in the developed world with inflation rates sometimes rising into double digits. This created much dissatisfaction both among consumers and businesses.

Much of the next two or three decades was spent designing a framework within which governments would have the responsibility for setting the inflation goal (e.g. 2% CPI increase p.a.) while giving central banks the day-to-day responsibility for implementing the monetary policies needed to achieve the designated target.

It is not credible, or likely in my view, that these efforts over the last few decades to achieve a low inflation environment will be jettisoned.

So, despite lots of discussion and media debate about financial repression (i.e. imposing losses on the holders of financial investments), I think this is not realistic.

There is too much at stake for the value of pensions, long term insurance policies and savings, all of which provide the seed corn for the capital investment that any growing economy needs.   

3. M2 has risen as can be seen in high savings rates. Given the still high level of uncertainty (unemployment, long-term effects of Covid, fears about the next crisis, etc.) is there a risk that consumers/businesses finally won’t put this money to work?

The high savings rates across many economies are essentially a result of the fiscal transfers and the inability of consumers to spend, particularly on high-contact services such as travel, hotels, restaurants etc. during the periods of lockdown.

But it is also true that much of the new money created has not yet been spent on goods and services. However, the new money has been used to purchase assets such as equities, homes and (more recently) commodities. Of course, that money does not disappear; it remains in the banking system ready for spending by the latest recipient.

I have strong confidence that the next stage of the transmission process of rapid money growth will see that excess money “put to work” through spending on goods and services.

The fundamental economic analysis underlying my confidence is based on the long-term behaviour of “income velocity” - the strong and predictable relation between money and spending.

Over the past several decades this metric has been on a steady downward trend (declining by about 2% p.a. in most developed economies). Translated, this means that people tend to hold more money per unit of income as they get richer. This trend is almost universal across countries, both developed and emerging.

However, during the pandemic the abrupt fall in spending and the steep rise in the amount of money has resulted in a sudden, sharp fall in “income velocity”, but whenever this has happened in the past in brief disruptive episodes such as Covid, velocity has returned to trend.

Trend reversion does not happen immediately and may take 2-3 years to return to trend. However, we can be very sure that it will happen. Translated, that means that the pre-Covid relation between money and spending will be restored over a period of 2-3 years. This in turn implies that during this period where the money-spending relationship returns to normal, spending will be slightly higher than normal.

Beyond the next two or three years the outlook for money growth, nominal GDP growth and inflation remains uncertain. It is possible that a tight regulatory environment could again result in sub-par money growth rates among leading economies, as we saw in the years following the Global Financial Crisis in 2008-09.

It is also possible, however, now that banks are much better capitalised and governments are keen to raise funding for strong, sustained recoveries, that money growth and spending are freed from the constraints of the past decade.

Only time will tell. 

4. How does the Euro area compare with the US and UK with money supply?

Money growth in the Euro area has not been nearly as rapid as in the US, and a little less than the UK.

Based on the latest available data (Macrobond, as at 1 March 2021), year-on-year growth of comparable money data was 25.6% in mid-February for the US (M2), 15.0% in January for the UK (M4x), and 12.5% in January for the Euro area.

Since all areas have the potential to grow at similar rates in real terms (1.5-2.0% p.a.) and have roughly the same rate of decline of income velocity (close to 2% p.a.), it is meaningful to make direct comparisons of these money growth rates.

However, it would not be meaningful to make a direct comparison with China where the real GDP growth rate is 5-6% p.a.

If money growth in the Euro area returns to the 5-6% range within the next six months or so,  it is probable that the region will experience only a temporary burst of inflation to perhaps 3-4% - most likely in 2022 - rather than an prolonged shift to above-target inflation and an unhitching of inflation expectations to the upside.

Otherwise an extended period of double-digit M3 growth implies the Euro area will also face a more protracted episode of inflation.