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In recent weeks, markets have become more nervous about inflation risks, with long-term inflation fears rising, spilling over into high government bond yields. One reason for the nervousness is strong monetary growth in the advanced economies. Six-month broad money supply growth has eased from its 2020 highs but remains elevated at around 10 percent (annualized) in the United States, the eurozone, and the United Kingdom.
Last September, we argued that the global monetary boom was no cause for panic because there were several reasons for thinking strong money growth would not translate into high inflation.
Has the picture changed since then?
The main driver of monetary growth in the past year has been large-scale asset purchases by central banks. These asset purchases accounted for 70-80 percent of total monetary growth at the end of 2020 in the US, the UK, and the eurozone.
The scale of asset purchases ought to shrink somewhat this year, although our baseline forecast still suggests they would add some 4-7 percentage points to broad money growth this year. And there may be upside risk to asset purchases in some economies given the high levels of budget deficits forecast this year (considerably up on six months ago).
Base for overall monetary growth
This would provide a substantial base for overall monetary growth this year. Add to that our forecasts for private credit expansion (the biggest counterpart to broad money), and broad money growth could reach 7-8 percent annually this year.
Other factors could boost it further. In the US, the running down of government deposits (which rose a lot last year, actually subtracting from money expansion) could add perhaps 1-2 percentage points. In all three economies, bank purchases of government bonds could plausibly add a similar amount, although there is considerable uncertainty around that.
Overall, it’s quite possible that broad money growth in the three economies could reach double digits between the fourth quarters of 2020 and 2021 on top of the very rapid expansion last year.
Supply constraints on credit to firms
Overall private credit growth has slowed in the US and the UK, although not so much in the eurozone. But it’s not clear whether the flat trend in private borrowing in the US and the UK will continue. In the absence of a major labor market shakeout, we doubt household credit will be very weak, so soft corporate lending is the more likely drag on money growth. Bank surveys do suggest corporate credit demand is soft at present. But they also suggest supply constraints on credit to enterprises are not going to be the sort of drag they were after the global financial crisis.
While corporate credit standards did tighten a lot for a couple of quarters in 2020 in the US, the latest survey shows only a slight tightening－this cycle may already be over. If so, the recent weakening of corporate lending in the US may give way to stabilization－as the data tentatively suggest.
What’s more, bank credit standards are not tightening across advanced economies as they did during the global financial crisis. Banks in the UK and Japan report a modest easing of loan standards, and even though eurozone standards are tightening, they are not doing so to the extent seen in 2007-08.
Savings unlikely to be released en masse
Specifically, velocity had declined late in the war against the financial crisis due partly to forced savings by goods-rationed households, and at least some of the rebound can be traced to these forced savings being released. Today, we have also gone through a period where savings have built up due to restrictions on spending－as these restrictions are phased out, these savings may be released and velocity could rebound. We have argued that it’s unlikely savings will be released en masse, but even a partial release might be enough.
Besides, unlike after the global financial crisis, bank credit is less likely to be stymied this time due to large volumes of bad loans (banks are better capitalized and benefit from widespread government loan guarantees) or by strong regulatory pressure to build capital and liquid assets.
In general, while private credit growth has slowed, it hasn’t done so enough to offset the central bank liquidity injections. Nor is it clear that it will. Indeed, economic reopening could give it a boost. So, money growth could stabilize at a double-digit annualized pace－as weekly data suggest is happening in the US, raising inflation risks.
An additional risk relates to changes in the behavior of enterprises and households as economies unlock, and in the behavior of the “velocity” of money (the rate at which money is exchanged in an economy). A key reason we were sanguine about strong money growth in 2020 was that massive uncertainties were boosting not just precautionary borrowing by enterprises but also the demand for liquidity more generally, and central banks were, correctly, accommodating this demand surge. In technical terms, the velocity of money had crashed so increased money supply was not inflationary.
But what happens as economies reopen? After the global financial crisis, velocity kept on declining (regulatory changes explain part of this, but not all of it) for several years. If this pattern repeats, high money growth may not be a problem. But it’s not clear this is the right model for what may happen now. In contrast to the global financial crisis experience, the US’ velocity recovered after the Great Depression in the 1930s and at the end of World War II.
Some savings may be released
The postwar example might be most pertinent for today. Specifically, velocity had declined late in the war due partly to forced savings by goods-rationed households, and at least some of the rebound can be traced to these forced savings being released. Even this time, we have gone through a period where savings have built up due to restrictions on spending－as these restrictions are phased out, these savings may be released and velocity could rebound. We have argued that it’s unlikely savings will be released en masse, but even a partial release might be enough.
Velocity might also rebound due to reduced financial and economic risk as COVID-19-related concerns disperse. Measures of this, such as bond spreads, are perhaps less useful than previously, given central banks’ interventions, but survey measures such as the US economic policy uncertainty index are currently dropping fast and have been associated with velocity shifts (albeit not consistently) in the recent past.
A rise in velocity would risk inflation overshooting targets in the advanced economies. If money growth runs at 8-10 percent this year in the US, the UK, and the eurozone but GDP growth is up to 6-7 percent, then with flat velocity, inflation ought to remain broadly in line with targets (based on the relationship: money growth x velocity= output x prices). But a rise in velocity, even of a few percent, implies inflation heading toward 5 percent.
Since inflation is an inertial process, it’s not a given it would immediately jump like this. But the upside risk to inflation is clear from the combination of economic reopening plus very stimulative policy. As a result, central banks will need to keep a close eye on inflation risk indicators in the coming quarters. It would not be too surprising to see some of them acting to rein in liquidity over the next year or so.
via HSN