Money is the root of all inflation


Had a blog on Quadrant Online on inflation. Basically gazumped by the Voice. So I thought I would share a slightly condensed version. Who knows some people might still be interested in economics, what with the Voice, climate change, transgenderism, and what not going on.

There’s lots of talk about Philip Lowe’s tenure at the Reserve Bank (RBA). He did very little wrong that other central bankers didn’t do. He was just too plucky in airing his ponderings that rates would remain close to zero until 2024. It would have served him better, as Yogi Berra and others reputedly said, to never to make predictions [aloud], especially about the future.

Central bankers are not free spirits. They tend to move as a pack. They all brought down interest rates too low and allowed inflation to gather speed. Then once it gathered speed their Keynesian economics, which led to the problem in the first place and which they all share, gives them no clear guidelines as to when enough is enough of interest rate increases.

You get this silly business of watching the latest inflation figures to guide policy. Economics 101: lags mean that the effect of policy is seen down the track. Current observations are usually misleading.

Another plague on good policymaking is to look at the relationship between interest rates (official cash rate now 3.35 percent) and inflation (December quarter 7.8 percent) and conclude that the real interest rate (3.5 minus 7.8) is negative and thus rates need to rise much further.

Current inflation is an irrelevant variable. Inflationary expectations are what count. And it seems likely that the current expectation is that inflation will fall. Equally, the interest rate to be considered is not the cash rate but the rate at which money can be borrowed by households and businesses and, moreover, set against the anticipated return on the money borrowed. Business is much more likely to be gung-ho when borrowing at, say, 7 percent when 17 percent is to be made, than if only 10 percent is to be made. It’s too complicated and we shouldn’t bother with it.

Instead of focusing on interest rates central banks should go back to Milton Friedman and focus on the growth of money aggregates. Inflation is a persistent increase in the prices of goods and services taken as a whole. Equivalently, it is a persistent reduction in the value of money. What leads to such a persistent reduction in the value of money?  Creating too much of it.

These days most money consist of bank deposits and the creation of most money is through bank lending. Nevertheless, the root cause, as ever, is governments spending more than they raise in taxes and borrowings. In turn, this increases deposits held by banks in central banks which provide the wherewithal for banks to lend.

What the RBA should do is to adjust interest rates to keep the growth in monetary aggregates under control. The focus should not be on the level of interest rates. That’s the instrument. The focus should be on the growth of money; that’s the target. Sure there are three or four different definitions of money. But an average of them all would do, save picking one – which would also probably do.

In the two years, between December 2019 and December 2021, according to RBA figures,  M1 money (cash plus bank current a/c deposits) increased by over 50 percent. M3 money (M1 plus other deposits in banks and in other authorised deposit-taking institutions) increased by over 23 percent.  During the same two-year period the economy (real GDP) grew by just 5 percent.  Bit of gap there. And it’s no surprise that excess monetary growth eventually finds its way into rising prices.

M1 peaked in May 2022 and has been trending down since. M3 is still going up but at a much reduced rate. Bank lending provides an early indication of what’s happening and the RBA should have intelligence on the very latest figures. The question is whether the RBA is focusing on the right variables – bank lending / monetary aggregates – or whether it remains besotted by the latest CPI figure. If it’s the latter it is bound to get it wrong in raising interest rates too much, as it got it wrong in reducing them too much.


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Anchor What
Anchor What
February 14, 2023 6:31 pm

We used to hear a lot about the “M3 money supply” back when our political climate was changing from conservative and careful to progressive and reckless. Journalists who didn’t really understand that sort of term any better than the average punter bandied it about to try and appear in the know.

These days journalists no longer bother to try and establish their economic credentials. They just assert that because they are a journalist that they know most things about most things. They have succeeded in bending our political outcomes towards the waste paper bin, towards national bankruptsy, towards energy poverty and thence real poverty.

flyingduk
flyingduk
February 14, 2023 7:12 pm

What the RBA should do is to adjust interest rates to keep the growth in monetary aggregates under control.

What the RBA should do is commit sepuku and leave the free market to regulate the nature of, supply of, and price of, money.

Money is just another good, and a century of attempting to centrally plan it has effed it up royally, and society and the economy to boot.

Petros
Petros
February 14, 2023 7:21 pm

What are Cats’ opinions of the Unholy Trinity of economics? Is an independent monetary policy the right way to go? I’m not an economist so keep it simple please.

Roger
Roger
February 14, 2023 7:56 pm

Peter, there’s soon going to be a vacancy at the top of the RBA; are you available?

billie
billie
February 14, 2023 8:05 pm

What flyingduk said .. leave it to the market

Why do we continue to have government organisations trying to manage the economy as if it is a train set and you just pull a few levers here and there and supposedly it all goes well. (but then it doesn’t and the RBA board are butthurt that people want them sacked – what a surprise that mst have been for them!)

If that were the case, that it is just pulling the odd lever here and there, why do we need very expensive people in supposedly prestigious positions doing it? Surely if the science is clear and obvious, why does it require specialists? It doesn’t seem too difficult to raise and lower interest rates. At the end of the day, that’s all the RBA does, and forks it up for F’s sake!

Why not just get the local newsagent manager or postie to do it? I’m pretty sure they coudn’t do a worse job, could they?

Now we have a Labor government who, once again, think they can “fix” the economy and want to play with the big train set where they have no skin on the line.

I feel sorry for the folks who have to deal with this in the marketplace, I’m on the fringe now and no longer suffer from idiotic government officials. It’s frustrating to watch it repeat edlessly though.

Elizabeth (Lizzie) Beare
Elizabeth (Lizzie) Beare
February 14, 2023 8:26 pm

Complicated indeed. Especially when they turn to printing more money as some sort of solution.

Inflation is being pushed along very nicely by the inflationary impact of increased energy prices on every single thing that is produced and transacted in this economy. The added costs are simply added on. That’ll do me for starters in explaining it.

But then, clearly I am not an economist. It has to be more complicated than that.
Aggregate money, and where it is held, etc etc.

WolfmanOz
February 14, 2023 8:31 pm

billie says:
February 14, 2023 at 8:05 pm

Great comment !

Boxcar
Boxcar
February 14, 2023 9:52 pm

As they say, if you want two opinions, just ask one economist, after all he be an expert on what happened yesterday.
In what world did these RBA clowns and their accomplices in the banks, both arguably some of the smarter people in the world, not know lower interest would and did create massive asset bubbles in housing and shares. Of course they did, and they kept doing it.
If they didn’t know what they were doing, how did they get there?
And if they did know what they were doing, whose agenda was at play.

One day in a decade, the Reserve Bank says inflation is rampant, and interest rates have to rise.
The entire economy falls into line, agree that it is definitely this or that causing it, and the banksters then start pushing rates up with gay abandon.
The politicians, too stupid to know how stupid they are, start echoing every economic cliche in the playbook.
A guy named Mattias Desmet recently coined the term “Mass formation”, and just maybe he is on to something.
What if Interest Rates and inflation are not economics, they are the “Next thing”

John Michelmore
John Michelmore
February 14, 2023 10:47 pm

I have some doubts about interest rates controlling inflationary prices in today’s economy. Prices go up for a number of reasons, and some have already noted this above. Government policies in particular increase prices. An example includes energy prices that are being increased by the fallacy that renewables are cheaper and just as reliable as fossil fuels, while the reliable energy sources are demonised and shut down, while nuclear is still not even on the table. The result is everything goes up as a result, because fossil fuels are used throughout the economy eg manufacturing, transport etc, resulting in all prices increasing. Unless there is a change away from existing only green climate policies, energy costs must increase irrespective of RBA interest rates.

Will
Will
February 15, 2023 9:26 am

When the government is both:
A) forcing up the cost of energy which is the most basic input into any product.
B) expanding the money supply through excessive borrowing.
Do you think just increasing the interest rate will stop any of these?

Vicki
Vicki
February 15, 2023 10:22 am

There’s lots of talk about Philip Lowe’s tenure at the Reserve Bank (RBA). He did very little wrong that other central bankers didn’t do. He was just too plucky in airing his ponderings that rates would remain close to zero until 2024.

Sorry, Peter – blind Freddy would know that an assurance such as Phillip Lowe offered to the economically naieve would be taken as verbatim from “on high”.

Those who follow other prognostications – especially OS commentators – would know of dire predictions regarding the onslaught of inflation in western countries. It is heartless to expect that the average new homeowner follows such information.

Old Goat
Old Goat
February 15, 2023 10:31 am

The way I see it when you create money and hand it to people who don’t produce anything you get inflation because you have more and more money chasing the same resources and services . Governments world wide are doing this to buy votes and they will continue to do this because they can . We are going to have to pay the price for this and all investigations into why it occurred will blame Trump, Russia , China or perhaps Toxic Masculinity – but no politician or bureaucrat will be held accountable .

Damon
Damon
February 15, 2023 12:35 pm

It is fortunate that Trump existed, otherwise he would have had to have been created. The Democrats have been running on him for the past six years, and have no other platform. Both Biden and Harris are jokes. Newsome has nice hair, but it’s not covering anything like a brain. Poor fellow my country indeed.

caveman
caveman
February 15, 2023 12:42 pm

What the RBA should do is commit sepuku and leave the free market to regulate the nature of, supply of, and price of, money.

Yeah, the duk. +1

Dot
Dot
February 15, 2023 1:52 pm

Very interesting.

https://mises.org/library/panama-has-no-central-bank

or a real-world example of how a system of market-chosen monetary policy would work in the absence of a central bank, one need not look to the past; the example exists in present-day Central America, in the Republic of Panama, a country that has lived without a central bank since its independence, with a very successful and stable macroeconomic environment.

The absence of a central bank in Panama has created a completely market-driven money supply. Panama’s market has also chosen the US dollar as its de facto currency. The country must buy or obtain their dollars by producing or exporting real goods or services; it cannot create money out of thin air. In this way, at least, the system is similar to the old gold standard. Annual inflation in the past 20 years has averaged 1% and there have been years with price deflation, as well: 1986, 1989, and 2003.

Panamanian inflation is usually between 1 and 3 points lower than US inflation; it is caused mostly by the Federal Reserve’s effect on world prices. This market-driven system has created an extremely stable macroeconomic environment. Panama is the only country in Latin America that has not experienced a financial collapse or a currency crisis since its independence.

Rufus T Firefly
Rufus T Firefly
February 15, 2023 4:27 pm

When the Govt spends money on project A, then Projects B, C, D, E, F, etc are that much worse off.

When our brilliant Treasurers, (like the half wit, previously known as the Member for Kooyong), decide to counterfeit, (also known as Quantitative Easing, QE), then everything suffers.
Breathtaking stupidity, unless one simply accepts, that these measures are designed, to inflict maximum pain on the great unwashed.

There is no action, these retarded f*%ks can take, that will “fix” anything, but they can certainly make people’s lives much worse.

Then there is the dolt currently in charge at the Reserve Bank.
Can anyone remember him, ever getting anything correct?

He should be charged with failing in his fiduciary requirements, then clasped to a gibbet, before a rising tide, as a warning to any other f*%kwit who also wants the job, with absolutely no knowledge of economics or respect.

JC
JC
February 15, 2023 7:29 pm

These days most money consist of bank deposits and the creation of most money is through bank lending. Nevertheless, the root cause, as ever, is governments spending more than they raise in taxes and borrowings. In turn, this increases deposits held by banks in central banks which provide the wherewithal for banks to lend.

Bank lending isn’t money. Credit is and never has been money. Credit is what it is. Credit, like a credit card can be cut off but a bank deposit or cash can’t be. Furthermore, bank lending is contained capital requirements and regulatory boundaries.

What the RBA should do is to adjust interest rates to keep the growth in monetary aggregates under control. The focus should not be on the level of interest rates. That’s the instrument. The focus should be on the growth of money; that’s the target. Sure there are three or four different definitions of money. But an average of them all would do, save picking one – which would also probably do.

The US tried targeting the monetary aggregates under Volcker at the time, but that didn’t work. So much for monetary aggregates.

I’m not sure that everything we count as inflation in the CPI is actually inflation of the type created by the central bank. We had an economic mess around the world with supply chain issues and then the war, which choked energy supplies. In other words, we had a series of supply shocks.

The mistake the RBA and other central banks made was to allow nominal GDP to rise to heady heights in the second half of 2021. However, the reason can be explained by the concern over the delta strain, which has caused governments everywhere to close the hatches. Instead, the central banks should have been tightening monetary policy then and signalling they wouldn’t allow nominal GDP to remain so high. A decent part of the inflation rate was a change in relative prices, though, due to energy and sticky supply chains.

JC
JC
February 15, 2023 7:34 pm

When our brilliant Treasurers, (like the half wit, previously known as the Member for Kooyong), decide to counterfeit, (also known as Quantitative Easing, QE), then everything suffers.

Japan has been episodically QE’ing since the last decade, and its inflation rate has been one of the lowest in the world. The way QE becomes inflationary is if the markets believe it will never end. Then you end up with hyperinflation, like in South America.

QE didn’t create the inflation of the present day. The RBA caused it by not being quick enough to tighten. I mentioned this above.

JC
JC
February 15, 2023 8:09 pm

Whoops

Wrong Fred.Please delete.

Zipster
February 15, 2023 9:18 pm

The question is whether the RBA is focusing on the right variables – bank lending / monetary aggregates – or whether it remains besotted by the latest CPI figure.

central banks are captured by MMT crapology to some degree, which is marxist economics of dense stupidity

Dot
Dot
February 16, 2023 8:01 am

The right figure is M1 (along with a long term trend of zero price level changes, but a moderate band of acceptable short term price volatility). M3 can moderate small changes in the real economy through credit contraction and expansion. Remember that M3 growth is causal to M1.

JC
JC
February 16, 2023 5:53 pm

Dot

Target the “‘sM” was tried in the 80s under Volcker. It simply didn’t work. Later on, Friedman suggested targeting aggregate income, which has now morphed into targeting nominal GDP. It would need to be forward looking by having an active futures market.

Dot
Dot
February 16, 2023 6:13 pm

I’m not suggesting targeting monetary aggregates alone. Call it quantum monetary policy if you like.

The Beer whisperer
The Beer whisperer
February 16, 2023 9:01 pm

What the RBA should do is commit sepuku and leave the free market to regulate the nature of, supply of, and price of, money.

It’s a monopoly, which creates shortages, in this case a shortage of opinions. I doubt opinions vary much between anyone on the RBA board. It’s an echo chamber of ideological Keynesians. This is why they are consistently wrong.

JC
JC
February 17, 2023 2:35 am

Dot

Here’s David Beckworth tweeting about the money supply.

https://twitter.com/DavidBeckworth/status/1622646090133536778/photo/1

There was a massive load on both the M2 and M4 between 2020 and half way through 2021.The United States then experienced “inflation,” which was caused by supply chain disruptions and a massive increase in the money supply. I’d estimate 1/2 each. So, given the huge increase in the money supply over 1 1/2 years, the US experienced perhaps 4% inflation while the balance was made up because of the supply chains. Money supply isn’t a great indicator. Beckworth asks a really great question. Where did the money go? My guess is that the money sat in banks or people simply raised cash and kept it at home. The money wasn’t spent.

JC
JC
February 17, 2023 2:48 am

Dot ,
This is interesting

St. Louis Fed M2 velocity It crashed in 2020 and then began to climb in 2021. I think this shows that even though the money supply blew out in 2020, M2 velocity just collapsed because of COVID reactions.

https://fred.stlouisfed.org/series/M2V

This suggests that the money supply is a subset of velocity when it comes to inflation. In other words, accommodating monetary policy requires a high V in order to see inflation.

Dot
Dot
February 18, 2023 5:43 pm

It does as M3 is causal to M1.

The CPI figures are terrible as a metric. The way they are calculated is antiquated to the point of dishonesty. The true CPI figure is nearly always higher than the government figure.

The transmission is largely indirect but it is far bigger than the official narrative says. It has to remembered that policy conditions are absurd. We have negative real rates in many countries and the quantity of money relationship breaks down in extreme conditions. QE or acute accomodation could be depressive to output and even prices (at least for CPI). It is possible to have lower purchasing power and prices and a loss of capital (actual productive fixed capital) – that is typical after a recession.

In 2019, there was a quiet accomodation to Australian M1. M3 barely moved. The change in M1 was large and acute. There could have been a banking crisis. I suppose it was a good thing we averted a disaster, but not many know why it happened (they know it happened at all) or how to avoid it in the future.

I am not convinced that residential property outstripping CPI 8.5 times in the last 40 years in Australia or increasing M0 by 300% during the forced recession of the COVID panic was good policy. The indirect channel has potential to do an awful lot of damage. We still have negative real rates after an economic recovery, low capital utilisation and a probable bank recapitalisation that carried on behind the scenes.

I’m worried. More so with our public debt, rising sovereign debt costs and an inability to rein in budgets.

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