The Global Risk Rises- and There Is No Way Around It

Money slows as credit grows… faster Money illusion is an economic term for the distortion that occurs when a significant difference develops between the money cost of an item and the economic burden of purchasing it. For example, I have joked that inflation has made me stronger because I did not used to be able to go to the store and so easily carry home $100 worth of groceries. The illusion in this example is that $100 worth of groceries is the same thing it used to be. Of course, I am not stronger. Inflation has not made me stronger. Inflation has made my load lighter by causing $100 to purchase less than it used to. Money illusion is meant to clarify the fallacy of thinking that your wages are really higher or that your income is higher because they have risen in dollar terms when inflation is growing faster than your wages or income are rising and when your purchasing power has fallen.

To clarify those points, I have created the table below that looks in the upper panel at nominal growth rates for money and credit and then directly below on the same frequencies creates growth rates for the inflation-adjusted (real) flows.

The nominal flows in the upper panel show that money supply is decelerating in the European Monetary Union; it grew at 7.7% over three years, at a 6.8% pace over two years, and at a 6.1% pace over 12 months, but over three months the annualized growth rate is now down to 4%. There is also a deceleration in the real balances on those same same timelines. Three-year real balance money supply growth in the EMU is 4% and over two years it's 1.5%, but over 12 months it's declining at a 2.3% annual rate, and over three months the money stock in real terms is falling at a 3.2% annual rate.

In both cases, money supply is decelerating. So in some sense, you could say that the signal is the same; however, since economists think that the absolute growth rate of money supply matters, there's a big difference between saying that money is growing at a 4% annual rate over three months or that the real money stock is declining at a 3.2% annual rate over three months.

Clearly the ECB policy has been tightening regarding money supply. Skipping past the credit columns for the moment, we see the same thing going on for money supply growth in the U.S. and in the UK, and to a lesser extent in Japan. The U.S. money stock decelerates from a huge 13.7% growth rate over three years to a decline at a 1.3% annual rate over three months. The U.S. real money stock grows at an 8.3% annual rate over three years but is now shrinking at an 11.1% annual rate over three months (yikes!). The U.K. shows money growth over three years at a 7.8% pace, decelerating to a 2.7% annual rate over three months. The U.K. real money stock grows at a 4.1% pace over three years and is now declining at a 10.2% annual rate over three months. Japan’s nominal money stock grows at a 5.5% pace over three years and slows to a 3.5% pace over three months. Over three years Japan’s real money stock rose at a 4.8% annual rate; over three months the real money stock in Japan is still growing but has slowed to a 0.7% annual rate. Japan had much lower inflation than elsewhere, as result its distortions and the unwinding of its distortions creates less distress.

These statistics make it clear that money supply has slowed, and that the real money stock is falling in most of the major money center countries. Looking at interest rates alone may hide the degree of tightening that we're seeing on the part of central banks. Of course, this judgment is always complicated because the money figures that are reported are called ‘money supply’ but they are, of course, the result of supply and demand interactions in the marketplace that occur as the central bank sets the short-term interest rate. So, for any given interest rate, if demand is shifting, that can cause a change in the money growth rate even as the central bank holds the nominal interest rate target steady. It's highly likely with the weakening economy in Europe that money demand is weakening and that the weakening that we see in the growth rates of the money stock reflect not just to squeezing by the central bank but also a pullback in money holding patterns on the part of the public.

The euro area offers an interesting presentation on what is going on with credit demand. Credit to residents in the European Monetary Union is up at a 3.9% annual rate over three years; that drifts down to 3.8% over two years but then ratchets up to a 5.4% annual rate over 12 months and further to 6.7% at an annual rate over three months. However, credit - deflated for the effects of inflation - shows three-year growth at a 0.3% pace falling to -1.3% pace over two years and falling to -3% over 12 months, then it ‘speeds up’ slightly to fall at a slightly slower -0.8% pace over three months. What we see here is that as nominal money supply has slowed, nominal credit growth has increased. This may be evidence that the tighter credit policies in the EMU are starting to work and that transactors have been forced into the credit market to borrow to meet their business and personal needs. While real money supply (demand?) is falling sharply in the EMU, real credit growth has also started to fall but is falling at a slower pace as nominal credit speeds up.

The same trends pertain to private credit in the EMU where the three-year growth rate for nominal credit is at a 4.2% pace; that accelerates to a 7.1% annual rate over three months against real credit balances that rise at a 0.6% rate over three years then drop to a -0.4% pace annualized over three months. The private sector in these credit statistics shows signs of being under stress and needing to increase credit use to stay afloat. I make this judgment rather than a judgment that the economy is speeding up and increasing its credit demands because the underlying economic statistics show there is economic slowing in place. When there is economic slowing, monetary tightening, and an increase in credit demand it is much more likely to be the product of distress.

What these money supply figures and the European credit figures tell us is that there is a monetary squeezing going on on a global basis. Just as World War II created a baby boom across all countries because they all experienced the same war at the same time, we now see this financial boom-bust relationship because of Covid having struck all countries at the same time and produce similar effects in all of these nations that are now redressing inflation’s rise on more or less the same schedule.

When global cycles become synchronized, the impact of policies becomes magnified. The risk in this process is that central banks looking at their own situation are going to overdo it and they are not going to properly take account of the tightening policies that are occurring at the same time in other markets.

An additional problem is that all of these countries have allowed inflation to get out of control at the same time. This means that all of them are chasing after a too high inflation rate from a too low interest rate base. And that's dangerous in each country, it's dangerous in all countries, and it is a danger magnified on a global stage.

Global macroeconomic models have never been particularly good at picking up all the interactive effects between economies. They work better for economists to demonstrate how some of these international linkages work and the kind of things we need to be aware of when we make policy by using simulations. Hopefully we learn these lessons and apply them. In this case, the lack of a precise understanding of the linkages puts the global economy even more at risk.

Little, to no choice for policy Having said that there's really little choice in the matter. If we look back at the late 1960s and early 1970s into the 1980s in the U.S., what is very clear is that chasing after inflation and reducing it but failing to extinguish it it's a very dangerous and bad policy. The fact that central banks now lack precise tools to calibrate what they're doing does not obviate that historical fact. In other words, there may be a greater risk of recession from central bank policies; however, it's still true that the greatest risk of all would be not to stop inflation. Central banks are lacking precise tools and calibration for what they're doing, still a Mini-Max strategy in this environment (a strategy that tries to minimize the worst thing that can go wrong if the central bank does the wrong thing) would still identify the worst risk as letting inflation get out of control. Despite the risks, central banks need to jump in with two feet and they need to stop inflation; they need to reduce it back to the level of their target. Failing to do this will only set the global economy up for much worse conditions down the road. That means only one thing. It's time to batten down the hatches.

Be careful what you wish for... As I finish writing this, I'm waiting for the Federal Reserve to meet to make its monetary policy decision for July. Markets clearly are looking for the Fed to give it some hint today about how it is about to slow or pause and for some - even pivot- monetary policy. Any of these communications would be a mistake. The Fed, like other central banks, is clearly behind the 8 ball and behind the curve and behind whatever you would construe as prudent policy for controlling inflation. Markets very much want to rally. Politicians very much want the unemployment rate to remain low. But then people always want to have their cake and eat it too. The Fed is not about the cake but the punch bowl and, in this case, it has not pulled it away quickly enough as former Fed Chair William McChesney Martin would undoubtedly agree. The Federal Reserve had been through a period where it is employed policies in which its reach exceeded its grasp. To put it another way maybe monetary policy which always considers itself to be the most sophisticated aspect of economics has undergone a collision with the Peter Principle and it has reached the height of its incompetence - its inability to deal with the reality it has created. Forward guidance may be the ultimate example of this sort of central bank hubris that when confronted with reality stopped working. In any event, people are poised for some news on the Fed that might say that the Fed is slowing its tightening. But with inflation still so high and so few signs of any deceleration and interest rates lagging so far behind the 12-month trailing inflation rate, this would not seem to be the most propitious time for the Fed to send such a communication. But, as always, we shall see.

Commentaries are the opinions of the author and do not reflect the views of Haver Analytics.