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Economy in Brief

As Inflation Overshoots, Are Central Banks Overdoing It?
by Robert Brusca  May 27, 2022

This report is a reminder of how complicated inflation and monetary policy making can be. As we all know, inflation has overshot globally - even Japan is finally getting a slight whiff of inflation reaching inflation benchmarks it long sought, however, doing it not exactly in the way it had hoped.

The table and the first chart show us that money supplies in nominal terms are still growing at a pace that appears to be a reasonable one to accommodate real growth and moderate inflation in normal times. However, these are not normal times. The European Monetary Union (EMU) shows money supply growth (M2) at 6.6% over 12 months. U.S. money supply is running hotter at 8% over 12 months, the U.K. (with a one-month lag) is running at 6.2%, with Japan at 3.6%. If you add up the potential real growth rate and desired inflation rate that sum should come close to the growth rate in money supply in an environment where velocity is stable, the economy is running at its potential, and inflation is at target. Money supply that has decelerated in all these countries for the most part has hit those markers and is still a little bit excessive. Annual money growth does not look too tight.

However, as we know, inflation is not running at its targeted rate anywhere. In fact, when we deflate money supply by inflation and calculate the growth rate, we have negative growth rates for money balances over 12 months (and more) in the euro area, in the U.S., and in the U.K., with Japan posting just one percent growth in the real money stock. In addition, credit measures in the European Monetary Area are contracting in real terms and are contracting on balance over two years in real terms. Has excessive stimulus led to excess discipline already?

The table and the first chart above show how money growth ballooned and deflated. The bottom panel of the table shows how real money supply is contracting sharply in real terms. However, this second chart shows how little central banks have done so far as official rates have barely moved. Still, money growth has nosedived and is contracting broadly in real terms. Central banks in some sense "have not yet begun to fight." Yet, they have pledged to fight mightily in the period ahead. The European Central Bank is planning to eliminate its negative rates, to cut down and stop its long-term asset purchases, and eventually to raise rates. The Federal Reserve has pledged to raise interest rates by 50 basis points at each of the next two meetings (at least).

We can peruse the data above and begin to consider what are the operative factors affecting money supply and inflation and monetary policy. Do central banks (still) have so much credibility that the mere mention and the taking of small steps to address a clear excessive inflation problem has caused markets to react ahead of them to redress the problem without as much central bank action? Or is the pull back in money growth evidence that there is already weakness in these economies and that money demand is already falling away and that with central banks holding an interest rate target given weaker money demand money supply growth rates are sharply lower? In the short run, it's hard to know what's happening and certainly some advocates of expectations theory are going to point to central bank credibility already having an impact without central banks doing very much. But is that really true?

With inflation still overshooting by a wide margin and with some evidence that it may already be starting to slow down, are these central bank pledges to raise interest rates so sharply going to turn out to be pledges that lead to an excess of action? Or is it true that looking back historically at interest rates, they are nowhere near as high as they need to be given current inflation rates to really reduce inflation back to target in a reasonable length of time? I hate to be such an economist, but on one hand, and then again, on the other hand….

The U.S. did post a negative GDP number for the first quarter of 2022 although that was mostly on the back of its volatile components: inventories and the current account balance (GDP net exports). However, final demand in the United States also slowed sharply. In some recent data, there is evidence that U.S. consumers still have firepower and may be spending beyond what some people thought they could sustain in the short run; but short run data are always volatile and can be misleading. Jobless claims in the U.S. remain extremely low, but there is an unmistakable uptrend to them. Europe has shown some weakening in the PMI data. China is being crushed and under tremendous pressure because of its ill-conceived goal of pursuing zero COVID infections. And there is the Russia Ukraine war….

For their part, economists are confused. Today's PCE data in the U.S. will encourage some to think that inflation is about to turn lower on its own and consumer spending is still apace. Maybe, it will, but that does not make inflation transitory in the sense that policy can ignore it. On the other hand, supply shocks continued to reverberate from COVID and new ones emanate from the Russia-Ukraine war theater especially as Russia uses the war to try to create a problem with global food supplies. That certainly doesn't cause us to think that inflation is or will soon be benign. Inflation, in fact, is difficult to measure when there are so many shocks through the system and difficult to forecast in that environment as well. It is especially difficult coming out of a period, as we are, in which global fiscal and monetary policy both pulled hard together to create growth and together certainly overdid it for a while. There are lingering lagged effects from that, as well as new forces, and unexpected economic tightness partly from a lower labor supply that resulted from changed worker behavior in the wake of the pandemic. Unique challenges keep piling up.

All of this combines to make us uncertain about the future. Uncertainty is certainly greater than normal. Economists will continue to have their opinions, they will belong to their different schools of thought, and they will reside in their chosen political spheres, and they will continue to try to drive the square pegs of economic reality through the round holes in which they believe.

And none of that will aid our understanding of where we are in this inflation fight or in determining what we need to do. In the end, everybody has realized that policy is not made by economic theory but by politicians. And politicians have had an outsized role in the way economic policy has developed since the pandemic struck. An awful lot has been done in the name of science, to run healthcare, to deal with 'climate change,' and for economic policy without much backing from science itself. Much has been done in the name of helping the disadvantaged (social justice). It is all squashed together. How much is enough? It is not clear when this period of distortion will end, when we will come back to our senses, and when we will begin to look at data and let the cold hard facts help us to make reasoned economic and broader policy decisions again. But even if that transformation happens tomorrow, it's not going to be easy because the situation… is complicated. It is made more complicated because we are human.

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

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