Asset Allocator Insights: The Macro Series, Part 1 – M1 and Inflation: Decoding the Trends The inflation surge observed over the past two years highlights that monetary creation cannot be ignored, even when other economic factors play a significant role. Reexamining classical economic theories in light of current realities makes it crucial for policymakers to balance economic stimulation with managing inflationary pressures.
For nearly three decades, marked by low inflation, the analysis of money supply as an indicator of inflation lost much of its relevance. In this context, traditional theories linking monetary creation to inflation appeared to lose their explanatory power, particularly given the price stability observed despite a significant increase in money supply. However, a recent study by the Bank for International Settlements (BIS), published in 2023, challenges this view and demonstrates that the link between money supply and inflation remains significant. The study highlights the resurgence of inflation through the lens of the quantity theory of money, reaffirming the fundamental connection between money supply and inflation. Nevertheless, the relationship between money supply and inflation is far more intricate than the quantity theory of money suggests.
1.- Theories of Money and Inflation
The impact of money on price levels is influenced by several factors, including economic activity, the amount of money created, who benefits from it, and its velocity of circulation. The relationship between money supply and inflation is more complex than the quantity theory of money suggests, often involving a lag between monetary expansion and the onset of inflationary pressures. This lag can lead to unintended consequences, as inflation may appear unexpectedly after a period of economic stability, making it more difficult for policymakers to predict and manage its effects effectively.
The Quantity Theory of Money
The classic theory of money, a cornerstone of classical economics, establishes a direct link between the amount of money in circulation and the level of prices in an economy. This relationship is often expressed through the following equation:
MV=PQ
Where: M represents the money supply,
V the velocity of money,
P the price level,
Q the quantity of goods and services produced.
According to this theory, there is a proportional long-term relationship between the growth of the money supply and inflation. This means that an increase in the money supply (M) leads to a corresponding rise in the price level (P), all other things being equal. In other words, inflation occurs when monetary creation outpaces real economic growth (Q), creating an imbalance between the amount of money in circulation and the available volume of goods and services. Too much money chasing too few goods results in rising prices.
Keynesianism vs Monetarism
The two major schools of economic thought, Keynesianism and Monetarism, differ in their views on the relationship between money and inflation.
Keynesianism: Founded by John Maynard Keynes, this school of thought emphasizes the role of aggregate demand (consumption, investment, and government spending) in the economy. Keynesians believe that inflation is mainly caused by demand-side pressures, especially when the economy is nearing full employment. According to Keynesians, monetary policy is useful for stimulating the economy during recessions, but the money supply is not necessarily a direct indicator of inflation. Thus, Keynesians favor active government intervention through fiscal policy and interest rate adjustments to manage inflation and support growth.
Monetarism: Popularized by Milton Friedman, Monetarism is based on the idea that inflation is always and everywhere a monetary phenomenon. Monetarists argue that excessive monetary creation inevitably leads to long-term inflation. They stress the importance of strictly controlling the money supply to prevent price fluctuations. Unlike Keynesians, Monetarists believe that active fiscal policies are often ineffective and can even exacerbate inflationary cycles by disrupting the economy.
2.- The Era of Unconventional Monetary Policies
This qunatitative theoryof money worked well during the 20th century, particularly in periods of high inflation. However, its effectiveness seemed to decline with the advent of inflation targeting by central banks starting in the 1990s.
The Role of Central Banks
Central banks, such as the Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of England, play a key role in regulating inflation through their monetary policies. By adjusting interest rates, managing the money supply, and purchasing assets, they influence the cost of credit, investment, and consumption.
Since the subprime crisis of 2007-2008, major central banks have implemented unconventional monetary policies, notably near-zero interest rates and massive asset purchase programs (Quantitative Easing). These policies have significantly increased the money supply, but contrary to traditional predictions, they did not generate a notable rise in inflation for several years. The gap between the increase in central bank money (held by commercial banks at central banks) and the absence of inflationary pressure has led many economists to question the validity of the quantity theory of money in this new context.
Traditional Models in Question
This gap between theory and reality has fueled debates about the validity of traditional models. Indeed, the low inflation during the 2010-2020 period led some economists to reconsider the classical relationship between money and inflation. Central banks themselves shifted away from monitoring monetary aggregates, focusing instead on direct inflation targeting through interest rates.
However, a study by the BIS published in 2023 challenges this perspective. It shows that greater attention to changes in the money supply could have allowed for better anticipation of the recent inflation. The BIS highlights that the rapid accumulation of liquidity injected into the financial system did not immediately lead to price increases due to weak overall demand. But as economies recovered, this liquidity began fueling excess demand, contributing to the inflation observed between 2022 and 2024.
3.- Understanding the Complexity of the Relationship
These examples illustrate that the role of monetary creation in the economy heavily depends on how it is used. Newly created money that flows into productive sectors or addresses demand deficits in underutilized economies may not be inflationary. However, when money is injected into sectors with limited supply or fuels speculative bubbles, it can create imbalances that are likely to trigger inflation.
If monetary creation is used to finance forward-looking projects, such as the energy transition, it can even help to moderate inflation in the long term by reducing costs for businesses and households, especially in the energy sector.
4.- Adjusting Monetary Creation During External Shocks
Inflationary pressures from monetary creation often arise when the newly created money does not contribute to productive activity. For instance, during external shocks (e.g., shortages, wars, natural disasters) that slow down production, monetary creation must be carefully calibrated to avoid exacerbating inflation. In such situations, monetary creation should ideally be directed toward investments that enhance productive capacity, mitigating inflationary effects over the medium and long term.
Comparison between the Annual Inflation Rate and the Annual Growth (in %) of M1 Money Supply in the Eurozone
Historically, the annual growth rate of M1 has often served as a leading indicator for the HICP inflation rate in the Euro area. Notable spikes in M1 growth in 2006, 2010, 2015, and 2021 were followed by corresponding increases in inflation, as reflected by the dashed line in the graph. These trends suggest a lagged relationship between money supply expansion and inflationary pressures, highlighting the influence of monetary dynamics on price stability over time.
Conclusion
The link between monetary creation and inflation is far more complex than the quantity theory of money suggests. Simply increasing the money supply does not necessarily lead to widespread inflation. What matters most is how the new money is used in the real economy. When directed toward productive investments or used to boost demand in underutilized economies, it can stimulate growth without causing inflation. However, in contexts where production capacities are fully utilized or speculative bubbles arise, monetary creation can drive up prices.
Therefore, for monetary creation to be beneficial and non-inflationary, it must be adapted to the economic context and directed toward sectors that can increase production. In times of external shocks, it is crucial to strike a balance between economic stimulus and managing inflationary pressures.
Reference : BIS Bulletin 67 , " Does money growth help explain the recent inflation surge?" Claudio Borio, Boris Hofmann and Egon Zakrajšek - Janaury 2023
Disclaimer Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This article does not constitute investment advice. It is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.
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