The “monetarist” rule of thumb that monetary changes feed through to prices with a lag of about two years suggests that G7 consumer price inflation will fall steeply from early 2023. 

G7 headline annual CPI inflation, as calculated here*, moved back up to 7.6% in September, just below a June high of 7.7%. 

A QE-driven surge in G7 annual broad money growth in 2020-21 was similar in magnitude to a bank lending-driven surge in the early 1970s. A peak in money growth in November 1972 was followed by an inflation peak exactly two years later – see chart 1. 

Chart 1

The 2020-21 money growth surge was largely complete by June 2020, although the final peak occurred in February 2021. The expectation here is that the June 2022 peak in CPI inflation will hold but the two-year norm suggests that a big fall will be delayed until after February 2023. 

Annual broad money growth collapsed from February 2021, falling much faster and further than after the 1972 peak. Then, money growth bottomed above 10% in 1975 and rebounded into 1976, remaining in double digits until 1980. Sustained strength allowed high inflation to become entrenched. 

Annual broad money growth is now below 4% (September estimate), with QT plans and a likely credit crunch suggesting further weakness. 

Money growth was relatively stable between 2013 and 2018, averaging 4.3% pa. CPI inflation averaged just 1.2% over 2015-20 (i.e. allowing for a two-year lag). Current monetary weakness suggests similar or lower inflation outturns in 2024. 

While headline probably peaked in June, core inflation continued to rise into September – chart 2. Core strength is feeding pessimism about inflation prospects, but shouldn’t. Contrary to popular mythology, core usually lags headline at turning points. Base effects boosted the G7 core annual rate over July-September but turn more favourable from October through next May (seasonally adjusted, the core index rose by an average 0.44% per month over October 2021-May 2022 versus 0.19% over July-September 2021). 

Chart 2

*GDP-weighted, Japanese September CPI estimated from Tokyo data.

Global six-month consumer price inflation peaked in June and fell further in August, reflecting pass-through of lower oil prices and a small decline in core momentum. Current commodity prices suggest a sizeable further drop into Q4 – see chart 1*. 

Chart 1

Annual as well as six-month CPI inflation probably peaked in June, with the peak occurring within the expected time band following a major top in annual broad money growth in February 2021 – money trends lead inflation by two to three years, according to the monetarist rule of thumb. 

G7 annual broad money growth is estimated to have fallen further to below 4% in August, widening an undershoot of its 4.5% average in the five years before the pandemic – chart 2. The suggestion is that G7 inflation rates will be back at or below target around end-2024, if not before. 

Chart 2

Markets were spooked by last week’s news of a hefty monthly rise in US core CPI in August but six-month momentum was little changed and below a June peak, while PPI pressures continue to ease – chart 3. 

Chart 3

Central bankers are supposedly focused on preventing high inflation from becoming embedded in expectations. The view here has been that expectations were unlikely to become “unanchored” against a backdrop of weak money growth. The latest consumer surveys by the New York Fed and University of Michigan show longer-term inflation expectations back within 2010s ranges – chart 4. 

Chart 4

UK annual core CPI inflation made a marginal new high in August but money trends mirror the global picture and are signalling a 2023-24 collapse – chart 5. The latest Bank of England / Ipsos inflation attitudes survey, meanwhile, reported a fall in consumer longer-term inflation expectations, which have remained within the 2010s range – chart 6. 

Chart 5

Chart 6

The apparent anchoring of longer-term US / UK expectations suggests that wage pressures will dissipate rapidly as current inflation rates fall sharply in 2023. 

*The GSCI commodity price index uses US prices for the natural gas component; the series shown by the gold line in the chart incorporates an adjustment for European prices.

Economic “optimists” argue that UK / US recessions will be avoided because households and firms have accumulated a “war chest” of excess monetary savings that will be deployed to support spending. The assessment here is that high inflation is rapidly eroding excess money balances while households / firms are unlikely to reduce precautionary savings against a backdrop of deteriorating economic / financial conditions.

Chart 1 is a recreation of one used to support the optimistic case. The suggestion is that UK households have amassed £170 billion of excess monetary savings, equivalent to 11% of annual disposable income.

Chart 1

A statistical issue here is the reliability of a measure of “trend” calculated over just two years.

More importantly, the demand to hold money depends on a host of influences, of which the most important is the price level. Any assessment of the magnitude of excess money balances should, at a minimum, take account of inflation.

Chart 2 recasts the analysis in real terms, while calculating “trend” over a 10-year period. The suggestion is that high inflation has already eroded a large proportion of the monetary excess, with the current deviation equivalent to 3% of disposable income.

Chart 2

Real money holdings were 2.7% above trend in April. Household M4 grew at a 4.2% annualised rate in the latest three months. If this pace were to be maintained, nominal money holdings would rise by 2.4% by Q4 2022. The Bank of England’s May forecast of CPI inflation of 10.2% in Q4, meanwhile, implies an increase in prices of 5.0% between April and then. These developments would result in real money holdings contracting by a further 2.5% by Q4. With “trend” increasing by 1.2% between April and Q4, the positive gap would be eliminated without any additional consumer spending.

March CPI numbers globally have mostly surprised on the upside (again) but monetary trends and other considerations continue to suggest significant relief in 2023-24.

G7 annual CPI inflation rose to 6.8%* in March, the fastest since 1982.

A post in September 2020 presented a “monetarist” forecast that G7 inflation would average 4-5% pa in 2021-22, i.e. between Q4 2020 and Q4 2022. Money growth in H2 2020 / 2021 was faster than assumed in the post and an outturn in the 5-5.5% range is now likely. (Annual CPI inflation was 4.9% in Q4 2021 and a retreat from the current level is likely over the remainder of 2022, partly reflecting commodity price base effects.)

The current inflation surge reflects a money growth surge in 2020 – G7 annual broad money growth* rose from 6.2% in February 2020 to 16.9% by June, eventually peaking at 17.3% in February 2021. This increase has now almost fully reversed, with annual growth estimated to have fallen below 7% in March – see chart 1.

Chart 1

Three-month annualised growth is down to about 4%, close to its average in the five years before the pandemic – chart 2.

Chart 2

Broad money growth has slowed by much more than after a comparable surge in the early 1970s. Annual money growth then bottomed above 10% before rebounding strongly, resulting in inflation remaining high and reaching a second peak in 1980.

Sustained broad money expansion of 4% would be consistent with inflation rates returning to target, though possibly not until 2024.

Will money growth stage a 1970s-style rebound? As previously discussed, this was triggered by monetary policy-makers abandoning restraint as economies weakened. Central bankers only recently shifted hawkishly and the hurdle for a policy U-turn is high.

The broad money slowdown partly reflects the winding down of QE, suggesting further weakness if QT plans are implemented. The proposed reduction of $95 billion per month in the Fed’s securities holdings is the equivalent of 0.35% of US broad money. The actual negative impact will be smaller because of various leakages, e.g. Fed disposals are likely to be partly absorbed by an increase in holdings of commercial banks (relative to a no QT scenario), implying a neutral effect on broad money. A reasonable assumption is a “multiplier” of 0.5, i.e. a drag on US broad money of 0.175% per month, or 2.1% over a year. This would cut 1.1 pp from G7 annual broad money growth.
 
With central bank actions on course to exert a negative impact, a rebound in money growth depends on “endogenous” strength in bank lending to the private sector. Monetary economists continue to debate this prospect. “Bulls” note a significant lending pick-up in recent months: G7 annual loan growth, adjusted for US PPP disbursements / forgiveness, was an estimated 6% in March, faster than in any month over 2009-2019. The suspicion here is that strength partly reflects the stockbuilding cycle, which is peaking, while recent yield rises will curb housing credit demand.

Central bank loan officer surveys are useful for gauging the outlook. The next Fed survey is due in early May but the ECB poll released last week signalled both a tightening of credit standards and weaker demand, suggesting that a recent pick-up in loan growth will reverse – chart 3.

Chart 3

The monetary forecast of 2023-24 inflation relief is supported by the assessment that the stockbuilding cycle is about to enter a 12-18 month downswing. The cycle is correlated with industrial commodity price momentum, which appears to have peaked – chart 4. Supply issues may constrain the downside but the wedge between G7 annual headline and core (i.e. ex. food and energy) inflation – currently 2.5 pp – is likely to narrow significantly in H2 2022 and may turn negative in 2023.

Chart 4

A “technical” factor promising CPI relief is a prospective reconvergence of consumer and producer prices of vehicles when supply constraints eventually ease. In the US, the CPI for motor vehicles would have to fall by 17% to eliminate a post-pandemic divergence with its PPI equivalent – chart 5. A PPI pick-up may bear part of the adjustment but the CPI vehicles index could plausibly decline by 10%, implying a 0.9% drag on headline CPI. A smaller but still meaningful effect is likely elsewhere.

Chart 5

*Own calculation using GDP weights.

The Chinese economy regained some momentum around year-end, as had been suggested by a turnaround in six-month real money growth in mid-2021. Monetary trends remain moderately hopeful but the recovery faces challenges from covid disruption, slowing global demand and ongoing property sector weakness.

Most official economic data are presented as year-on-year growth rates. Chart 1 shows estimates of seasonally adjusted levels for key series derived from the year-on-year numbers. Industrial output rose strongly between October and January / February, more than reversing weakness earlier in 2021. From the demand side, exports and government investment appear to have been key drivers, possibly supplemented by stockbuilding. Retail sales and private investment rose slightly in value terms, while home sales recovered following a precipitous drop.

Chart 1

Six-month growth rates of money and credit bottomed over May-July 2021 but a strong rebound in broad money expansion during H2 wasn’t matched by narrow money, tempering optimism here about a likely economic reacceleration. Narrow money growth firmed in February but a further rise is necessary to warrant a positive view – chart 2.

Chart 2

The money growth recovery has been larger in real terms because of a slowdown in six-month consumer price momentum since mid-2021, with higher energy costs more than offset by weakness in food prices – chart 3. This tailwind may be about to reverse, with wholesale price data suggesting a rebound in food inflation – chart 4.

Chart 3

Chart 4

The Evergrande crisis threatened to tighten financial conditions and abort the money growth recovery. Three-month SHIBOR firmed in late 2021 but retraced the move in January / February, stabilising recently – chart 5. A further fall would be welcome confirmation that the PBoC remains on an easing tack, supporting hopes of further monetary improvement.

Chart 5

Why did high inflation become entrenched in the 1970s?

The consensus view is that an initial inflation shock became embedded in expectations, resulting in inflationary price- and wage-setting behaviour.

The “monetarist” view is that the underlying driver was sustained high money growth, which played a key role in allowing inflation expectations to become dislodged.

A surge in G7 annual broad money growth to a peak in November 1972 was followed by a surge in annual CPI inflation to a peak two years later – see chart 1.

Chart 1

Broad money growth showed a similar surge to an initial peak in June 2020 and CPI inflation may top out in mid-2022. The ultimate peak in money growth was in February 2021, suggesting that inflation will remain high into 2023.

Monetary authorities responded to the 1973-74 inflation surge by tightening policy aggressively – see chart 2, which overlays a weighted average of G7 short-term interest rates. They had ignored the inflationary warning from money trends but displayed Volcker-esque zeal in attempting to correct their mistake.

Chart 2

Policy tightening resulted in a major monetary slowdown over 1973-75. With inflation continuing to surge, real money balances plunged and economies moved into recession.

The critical policy error occurred at this point. While money growth had fallen significantly, it remained high by historical standards and inconsistent with a full reversal of the inflation rise. Yet policy-makers performed another U-turn as recession unfolded, cutting interest rates as aggressively as they had raised them.

The result was that G7 broad money growth bottomed out above 10% in early 1975 and rebounded into 1976. Short rates were held at their lower level despite persistent high inflation and money growth remained above 10% until 1979.

What are the lessons for today?

While rate rises are only beginning, the view here is that there has already been a major “tightening” of policy in the form of the cessation of QE and shift to hawkish forward guidance. In the US, this is captured by a 210 bp rise in the Wu-Xia shadow fed funds rate between November and February. (The corresponding UK shadow rate has risen by an astonishing 10.2 pp since January 2021).

Consistent with this interpretation, annual broad money growth fell to an estimated 7.5% in February, with the three-month annualised rate of increase down to 5%.

With CPI momentum still rising, real money balances are now contracting and recession risk has risen. The real money squeeze, however, is mild compared with 1974-75.

On current trends, the monetary backdrop will soon be compatible with an eventual return of inflation to targets, although possibly not until 2024.

Central banks face opposing risks. If they raise rates in line with expectations, monetary trends could weaken further, causing unnecessary economic damage and a medium-term undershoot of inflation targets.

If they back off, however, money growth could stage a 1975-style rebound at a time when inflationary expectations are showing signs of becoming “unanchored”.

The judgment here is that the former risk is much greater.

A key point is that high money growth in the 1970s reflected underlying strength in private sector credit demand. The 1974-75 rate cuts, therefore, resulted in a big rebound in bank lending expansion, which underpinned inflationary money growth – chart 3.

Chart 3

The 2020 surge in money growth, by contrast, was entirely due to QE (more precisely, monetary financing of fiscal deficits). Bank lending expansion has risen recently but is nowhere near the levels reached in the 1970s, or even the noughties.

The upshot is that money growth is unlikely to rebound strongly if central banks back off from rate rises – assuming no return to QE.

Policy-makers should monitor monetary trends and adjust their stance accordingly – in a dovish direction if the recent slowdown extends or hawkishly in the unlikely event of a reacceleration. Astonishingly, they continue to deny any linkage between the 2020 money growth surge and current inflation problems. Such denial is a recipe for more bad decision-making and 1970s-style economic volatility.

Eurozone monetary trends were arguing against ECB policy tightening before the negative shock of Russia’s invasion of Ukraine.

Three-month growth of non-financial M3* – the preferred broad money aggregate here – slowed further to 4.2% annualised in January, the lowest since January 2020 and below a mean of 4.9% over 2015-19, when CPI inflation averaged 1.0% – see chart 1.

Chart 1

Current high inflation reflects excessive money growth in 2020-21 and supply side disruption. It is too late for an ECB response. Any second-round effects will swiftly burn out if money growth maintains its recent subdued pace.

The broad money slowdown has occurred despite ongoing QE, raising the prospect of outright weakness when it stops. The hope is that money growth will be supported by private credit expansion, which has strengthened recently – chart 1. The suspicion here is that corporate loan demand has been boosted by restocking and will fade as this slows.

Growth of narrow money (non-financial M1) has also normalised while high inflation has pushed the six-month rate of change in real terms marginally into negative territory – chart 2. Negative readings preceded every recession over 1970-2019, although there were several false signals (e.g. 1994-95) – chart 3.

Chart 2

Chart 3

The six-month rate of change of real narrow money deposits is now negative in Italy as well as Germany, with France still showing relative resilience – chart 4.

Chart 4

*M3 holdings of households and non-financial corporations.

Recent market weakness reflects an unfavourable monetary backdrop as well as negative geopolitical developments.

The monetarist view is that asset prices respond to imbalances between the supply of money and the demand to hold it. “Excess” money growth is associated with increased demand for financial assets and upward pressure on their prices, assuming no change in supply.

Excess money growth can’t be measured directly because the demand to hold money – based on current economic conditions and prices – is unobservable. Two proxy measures of global excess money are tracked here: the difference between six-month growth rates of real (i.e. CPI-deflated) narrow money and industrial output; and the deviation of 12-month real money growth from a slow moving average.

Historically, global equities outperformed cash significantly on average when both measures were positive but underperformed significantly when both were negative. Mixed signals were associated with a small return shortfall, i.e. no reward for assuming equity risk – see table 1.

Table 1

A post in early January noted that the second measure had turned negative in October while the first appeared to have followed in November, based on partial data. This “double negative” signal was confirmed later in January.

A January estimate of global real narrow money is now available, along with a firm data point for December industrial output. Both excess money measures remain negative.

12-month growth of global real money is estimated to have fallen further below its moving average in January – chart 1. An early reconvergence seems unlikely – CPI inflation is probably peaking but a decline may be offset by a further slowdown in nominal money growth as large monthly increases a year ago drop out of the 12-month comparison.

Chart 1

Meanwhile, six-month real narrow money growth was little changed in January and below December industrial output growth – chart 2. Six-month output growth may stay at or above the December level through March: a temporary production catch-up is in progress as supply constraints ease, US output rose solidly in January and base effects are favourable (output fell between June and September 2021).

Chart 2

The excess money measures have also been correlated with sector relative performance historically, with double negative signals associated with strong outperformance of the defensive sectors basket (which includes energy) and underperformance of cyclicals, including tech (IT and communication services) – table 2.

Table 2