Alice Cook claims that the fact that monetary growth is accelerating is the “most difficult” fact for forecasters of deflation. It’s not. The link between growth in M4 - which is currently running at 18.8% - and inflation is very weak.
Just look at my chart. Can you see a strong link between the two? Granted, the acceleration in M4 growth in the mid-00s led to a rise in inflation last year. But if you wait long enough, you can get that sort of link between any two data series.
Over the last 20 years, M4 has risen 450% whilst the RPIX index has risen just 90%. Which suggests the long-run relationship between the two isn’t any better than the short-run link.
If you want a more sophisticated take, try this paper by David Hendry and Jennifer Castle, which models inflation with little role for M4 growth.
This is not to say M4 has zero impact on inflation. This paper by Costas Milas estimates that, when monetary growth is above 10%, “a 1 percentage point increase in the annual growth rate of M4 increases annual inflation by only 0.09 percentage points.”
But this effect is small. The M4 stock is currently £2 trillion. So the first £75bn of quantitative easing will increase it by just 3.75%. On Milas’ calculation, this would add just over 0.3 percentage points to inflation. Which isn’t much.
Now, a lot of what you read on this blog is eccentric and out-of-consensus. But on this point, I’m with the mainstream. Breakeven inflation rates for gilts of less than eight years maturity are under 2 per cent, suggesting markets aren’t worrying about money-fuelled inflation. And the Treasury’s survey (pdf) of economists shows that the average forecast for CPI inflation at the end of 2010 is just 1.6%, with the highest forecast, from Citigroup’s Michael Saunders, at 3.7%.
Let’s be clear. I’m not sure inflation will fall very sharply, except for mathematical reasons - not least because the UK’s Phillips curve is a queer shape; some of Alice's other points are reasonable. But to expect it to rise a lot because M4 is growing a lot is to lose touch with the facts.
Just look at my chart. Can you see a strong link between the two? Granted, the acceleration in M4 growth in the mid-00s led to a rise in inflation last year. But if you wait long enough, you can get that sort of link between any two data series.
Over the last 20 years, M4 has risen 450% whilst the RPIX index has risen just 90%. Which suggests the long-run relationship between the two isn’t any better than the short-run link.
If you want a more sophisticated take, try this paper by David Hendry and Jennifer Castle, which models inflation with little role for M4 growth.
This is not to say M4 has zero impact on inflation. This paper by Costas Milas estimates that, when monetary growth is above 10%, “a 1 percentage point increase in the annual growth rate of M4 increases annual inflation by only 0.09 percentage points.”
But this effect is small. The M4 stock is currently £2 trillion. So the first £75bn of quantitative easing will increase it by just 3.75%. On Milas’ calculation, this would add just over 0.3 percentage points to inflation. Which isn’t much.
Now, a lot of what you read on this blog is eccentric and out-of-consensus. But on this point, I’m with the mainstream. Breakeven inflation rates for gilts of less than eight years maturity are under 2 per cent, suggesting markets aren’t worrying about money-fuelled inflation. And the Treasury’s survey (pdf) of economists shows that the average forecast for CPI inflation at the end of 2010 is just 1.6%, with the highest forecast, from Citigroup’s Michael Saunders, at 3.7%.
Let’s be clear. I’m not sure inflation will fall very sharply, except for mathematical reasons - not least because the UK’s Phillips curve is a queer shape; some of Alice's other points are reasonable. But to expect it to rise a lot because M4 is growing a lot is to lose touch with the facts.
I've always thought inflation was much more allied to the exchange rate and Union greed....
Posted by: kinglear | March 26, 2009 at 04:20 PM
All this misses the point. The Bank of England's quarterly inflation report produces an adjusted M4 series (see Chart 1.2), and has done at each inflation report since August last year. This shows adjusted M4 growing at just 3.8% annually and having dropping like a stone - implying three-monthly negative growth. Back in 2006 adjusted M4 was growing at above 14%, and the average since 1992 is 8%. There is a very significant monetary contraction going on, implying considerable deflationary pressure.
Posted by: Andrew Lilico | March 26, 2009 at 04:46 PM
The adjustment Andrew refers to simply strips out financial institutions' cash holdings, to leave households and companies' bank deposits.
I agree - and indeed said so in my day job some time ago - that the fall in the latter is a recessionary sign. However, the fall seems to have stopped recently:
http://www.bankofengland.co.uk/statistics/fm4/current/index.htm
Posted by: chris | March 26, 2009 at 06:08 PM
I really don't get why USA is undergoing recession. They seem to be dug deep into money problems. What happened to Uncle Sam?
Posted by: Svenson in Australia | March 27, 2009 at 05:07 AM
don't you need to strip out the influence of the velocity of circulation before you can make sense of this data?
Posted by: diogenes1960 | March 30, 2009 at 10:51 PM
nah I don't get that people still talk about the Phillip's curve. Its not a theory or set of observations that has been conclusively proven. Data is volatile. There is no proven automatic link between inflation and unemployment. There is a relationship, but no-one know's that it is causal for sure.
Better as the Phillip's theory?
Posted by: Glenn | April 07, 2009 at 12:22 PM
And a lot of it reflects a switch from bank deposits to securities; foreigners “other investments” in the UK, http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html
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