Opinion: Bank of Canada may have to come to terms with money supply to stabilize inflation

The Bank of Canada building on Wellington Street in Ottawa on May 31.Justin Tang/The Canadian Press

Forty years ago – or about the last time we had inflation rates as high as they are today – central bankers had an unfortunate divorce from the money supply. It has proven too volatile and unpredictable to be a reliable partner in setting monetary policy, they concluded.

Gerald Bouey, the Governor of the Bank of Canada at the time, lamented, “We didn’t give up M1, M1 gave up on us,” referring to the primary measure of money supply.

But now some economists and central bank critics think it might be time for at least some reconciliation.

A research paper by Professor Steve Ambler of the University of Quebec at Montreal and CD Howe Institute Deputy Research Director Jeremy Kronick, published by the institute this week, found evidence that there is still a relationship between the long-term trend of money supply growth and inflation. Moreover, this relationship has remained intact over the past three decades, during which the Bank of Canada has pursued a 2% inflation target as its guiding policy objective – largely ignoring monetary aggregates such as M1 and M2. broader in this pursuit.

“Controlling monetary growth rates is essential for stabilizing inflation,” the document concludes.

Mr. Ambler and Mr. Kronick are far from the only ones taking a closer look at the money supply. The current global inflation situation has raised many difficult questions about central bankers’ beliefs and assumptions about the mechanics of inflation.

For some, especially those who question the competence and even the motives of central banks, the monetarist arguments for inflation are irrefutable proof. Central banks created a massive spike in the money supply through quantitative easing (and governments put it into circulation through emergency pandemic support); a massive spike in inflation ensued, after a certain lag; so central banks created this monster, ignoring everything the economist Milton Friedman taught us about money. (“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can only be produced by a faster increase in the quantity of money than in production.”)

Mervyn King, who was Governor of the Bank of England from 2003 to 2013, wrote recently that the world’s central bankers have come to see their inflation targets as pillars of virtue in themselves – as long as they could keep consumer inflation expectations around the target, inflation would always return to that target. In doing so, he said, central bankers overlooked the economic mechanisms involved.

“The old idea that inflation reflects ‘too much money for too few goods’ is more plausible than the view that it is driven solely by expectations,” he wrote in an article by opinion published by Bloomberg. “The fact remains that we have experienced a substantial, albeit transitory, increase in the growth rate of broad money, and we are now experiencing a notable, albeit perhaps transitory, increase in inflation.”

But even Mr. Friedman himself acknowledged that the money supply was an ugly target for central bankers to control inflation. The experience of the 1970s and early 1980s established that it was simply not possible to obtain an effective reading of the evolution of short-term inflationary pressures, and that targeting a level of money supply also did not have the desired effect on output and prices.

Inflation targeting, on the other hand, worked wonderfully well for a long time. Until it doesn’t.

Mr. Ambler and Mr. Kronick said that as long as the public’s inflation expectations remain firmly anchored around a central bank target, there doesn’t appear to be much correlation between short-term movements in money supply and subsequent inflation rates. . But when those expectations are no longer anchored to that goal, the relationship between inflation and money supply reappears.

The Bank of Canada maintains that this has not yet happened. But its own surveys of businesses and consumers suggest otherwise, at least over the usual two-year horizon on which the bank bases its interest rate policy.

The bank’s quarterly survey of Canadian consumer expectations, released on Monday, showed Canadians expect inflation to still be around 5% in two years’ time, up sharply from 3% the third quarter of 2021. The online Pulse survey, also released on Monday, pegged inflation at 3.4% two years from now. While consumers and businesses still generally believe the Bank of Canada can eventually bring inflation close to its target, polls have shown cracks in that confidence.

Mr. Ambler and Mr. Kronick say that as long as we are in this period of what they call “unstable” inflation, the money supply will serve as a key catalyst for controlling prices and a valuable indicator of inflation prospects. They said the central bank’s shift to reducing its holdings of government bonds – known as “quantitative tightening” – is an important step to dampen money supply growth, but they said warned that it will take up to two years before this results in a reversal of the associated inflationary trend.

“Silver should be reintegrated by the Bank of Canada into its forecasting and monetary policy processes,” they wrote. “More timely measurements of these aggregates would be a good start.”

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