Tumbling money supply alarms economists who foresaw inflation

Britain's money-supply economists, who emerged from obscurity in the pandemic by correctly anticipating sky-high inflation before anyone else, are sounding the alarm again. 

Money supply growth is collapsing in the UK, eurozone and US, and they read that as a warning of recession and deflation. Central bankers have raised interest rates too far and, if the so-called monetarists are proved right again, they say there should be a "clear out" of officials.

Those views are held by British economists Simon Ward, economic adviser to Janus Henderson, and Tim Congdon, the UK's leading voice on the subject and once an adviser to Margaret Thatcher when she was prime minister. 

Their analysis jars with the mainstream consensus that economies are starting to pick up and inflation was primarially caused by supply shocks and energy prices. But for monetarists, growth and inflation are a function of the quantity of money in circulation and its velocity — the number of times it changes hands. Those measures are now pointing to a slump.

Congdon and Shaw have argued that central banks' vast quantitative easing programs and sharp rate cuts in the pandemic led to double-digit money supply growth across the US and Europe. A year later inflation was above target and on course for 10%.

Today, money supply is plummeting. In the eurozone, the six month rate of change of M3 broad money, which measures deposits and cash equivalents of up to three year maturities, is the weakest since the aftermath of the financial crisis in 2010. M1 narrow money, cash and overnight deposits, is negative for the first time since the currency bloc's birth in 1999, RBC Capital Markets strategists said.

In the UK, real M4 growth – cash and sterling liabilities of up to five years – has fallen steeply below trend, Ward said. "Annual broad money growth rates in the UK and Eurozone are well below their 2010s averages – associated with below-target inflation," Ward said by email. "This is extremely worrying and suggests recession, disinflation and deflation."

Vincenzo Inguscio, a London-based volatility strategist at Nomura, warned that a recent contraction in the US of M2, which measures cash in circulation plus dollars in bank and money-market accounts, suggests the Federal Reserve has pushed too hard on the monetary brakes. "People need to keep an eye on the money supply dynamic when it swings so much," he said.

To tackle the highest inflation in four decades, central banks have raised rates at the fastest pace since the late 1980s and are shrinking QE to cancel the money they created. Congdon says the money data shows they should have stopped hiking some time ago. 

Similarly, Ward wants officials to stop shrinking their balance sheets through so-called "quantitative tightening." Cutting rates should even be considered, "probably by a lot."

"They need to restore positive money growth," Ward said. "The monetarists won the inflation forecasting contest, but the central bankers claim that was a fluke. Now for the rematch. If the central bankers lose this one, and we move into recession or deflation, will there finally be a reckoning and clear-out?"

Falling money supply may anticipate deflation but it may also simply reflect the recent banking crisis and instability in financial markets caused by the aggressive rate-rising cycle.

Crisis Response

The UK central bank owns more than half the conventional gilts in issue

RBC says eurozone money is merely rotating to other areas of the banking system but, even so, "loan and money creation is slowing down dramatically in the euro area." Trends are more concerning in the US, it added, where deposits are "exiting the banking system" and putting "liquidity pressures" on the banks.

Ward said the banking turmoil threatens to make the money supply crunch worse, as lenders "turn risk averse" and restrict credit. For Congdon, the issue is severe enough to warrant a change in the central bank framework. 

He wants the BOE's open letter system, under which the governor must explain to the Chancellor of the Exchequer why inflation is more than 1 percentage point off target, to incorporate a reference to broad money.

"The quantity of money must be on the central bank dashboard. If it is not there, central bankers will be as dangerous as people who drive cars without looking at the speedometer," he said.

Congdon believes "the Fed, the ECB and the Bank of England are all to blame for the far above-target inflation rates from which their economies now suffer." He added: "They will also be to blame for the recessions that will hit these economies from mid-2023." 

BOE officials have pushed back. Silvana Tenreyro, an external member of the monetary policy committee, says it is wrong to blame QE for soaring price growth. "QE affects the economy only to the extent it affects interest rates. There is no separate 'money' channel that can unleash inflation," she said at the Scottish Economic Society annual conference in Glasgow last Tuesday. 

In a speech last year, ironically titled "What did the monetarists ever do for us?", BOE Chief Economist Huw Pill argued that modern economics embraces some monetarist ideas but rejects how it views policy is transmitted because that is "widely seen as discredited" since the mid-1980s, when Congdon was at his most influential.

"I doubt that monetarism will be embraced by either the academic or central bank communities in the coming years," Pill added. A BOE spokesperson declined to comment.