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ECODATE

Volume 36, Issue 3 2022

ECODATE

Volume 36, Issue 3, 2022

Looks like Milton Friedman was right about global inflation

Adrian Blundell-Wignall, Economist

Abstract

We are in uncharted waters and care needs to be taken to avoid further policy mistakes in Western central bank policies. Friedman’s main insights with a global tweak might be helpful in that rethink.

Article

Milton Friedman always asserted that inflation was everywhere and forever a monetary phenomenon. Central banks and post-Keynesian economists were very happy to ditch this thinking at the first sign of instability in the relationship. Monetarism was “cancelled”. Inflation targeting based on forecasting became the dominant way of thinking about inflation and the running of policy. And look where we have ended up.

Figure 1: A shopper in Berlin as inflation pushed the European Central Bank to its first rate rises in a decade. Source: AP

For many years, central banks wrongly took credit for observed low inflation; that their policy targets gave rise to “credibility” and tamed expectations, so that ultra-easy policy after the global financial crisis wouldn’t cause inflation. It was never thus. 

Globalisation and the China supply shock were ramping up at the same time. Import competition, the Amazon/Walmart effect and job fears as businesses restructured to take advantage of structural change resulted in less secure jobs and low wage outcomes for ordinary workers.

Well, guess what happens when China begins to run into its own structural problems and then shuts down its economy due to COVID-19 – not once but twice – just as the West pumped up nominal demand via money in the hands of households?

Today, it’s not just domestic money that matters. In a globalised world, what other countries are doing matters too. Global money facilitates nominal demand for supplies coming from many new parts of the world. Prices are affected for everyone.

Looking in the wrong places

If we add up US, European and Japanese money supplies in US dollars and compare it to US inflation (as a world inflation pressure indicator), an interesting picture emerges. Global money has been a reasonable lead indicator of inflation since the financial crisis. Central banks that all failed to forecast the outbreak of inflation certainly weren’t looking at the money supply.

Most recently a new inflection point has emerged in the downward direction. The monetary variable has dropped sharply, stretching the “elastic band” with inflation to breaking point. Something is going to happen as a consequence, and it may be unpleasant. There are two reasons for the sharp money reversal (none of which relate to central bank quantitative easing policies).

The first reason is that COVID-19 payments, which had for the first time since the global crisis pushed a lot of money into the bank accounts of households (not the deposits of banks at the central bank), fell back to zero. Then COVID-19 money dropped out as a source of new nominal demand this year.

Figure 2: US, Europe, Japan money supply Vs US inflation and China supply (% p.a.). Money from the US, EU and Japan refers to M2. The China supply variable is based on tax collection, highway freight, construction, electricity output, steel production, and real M2.

The second reason is that the Fed, realising its errors, has begun tightening more quickly than other central banks and the dollar has surged. This is pushing down purchasing power in Europe and Japan. The dashed line in the chart shows what the path of global money would have looked like in US dollars if the exchange rate had remained fixed at the level in June last year.

Instead of minus 3.8 per cent, the number would have been 5 per cent to 6 per cent. That differential of 9 per cent to 10 per cent reflects the cost-of-living pressures being transmitted outside the US by the dollar. Their international purchasing power in global supply chains is falling, including for the politically sensitive cost of food and fuel. This will weaken demand outside the US and wages are not keeping up.

The ECB and Bank of Japan need to get on with it. They could do something to affect their purchasing power by co-ordinating their monetary policies more closely with the US. But they feel constrained.

Japan’s easy policy is a long-standing Mercantilist belief in exchange rates to stimulate exports. The ECB case is more complex. They are stuck in their ill-conceived currency union. They don’t want to blow-up Italy and take Europe back into its shadow currency crisis of 2009-10 that manifested itself as a sovereign debt crisis. Higher rates might do that.

Cracks are showing

The other element in the inflation story is the path of the “China shock”. Growth of the supply measure in the chart has declined since 2014 because of China’s own structural problems. These have been followed up by the two shutdowns due to the mismanaged Covid pandemic.

Believing in a destiny not hampered by democratic processes and market discipline, China has been building debt at unprecedented pace. At the end of last year, its debt rose to 287 per cent of GDP, surpassing the US (a much richer country) at 281 per cent. Astounding really. Excess investment is present in many Chinese industries.

Perhaps the most compelling observation is that large cracks are appearing in the signature project of President Xi Jinping, the Belt and Road Initiative. New large construction projects are drying up.

This year only East Asia (where Chinese political power is strongest) has received any reasonable inflows, including in Papua New Guinea, the Philippines, Laos, Indonesia and Thailand, all very close to home.

Direct investment in foreign companies has fallen even more sharply and troubled transactions are rising. Many investments have been misjudged (including in Australia). The absence of market discipline will do that.

Although it is difficult to imagine a China credit-driven supply response like that of 2008-09, there will be a strong but temporary bounce as the COVID-19 shutdowns are lifted. More moderate growth will then follow.

The supply side will improve, though not to what it was in the 2007-14 disinflation period.

Summary

Summing it all up, the trends in the chart suggest inflation will fall in 2023. But the sharpness of the money reversal also suggests that recession is now a serious risk.

We are in uncharted waters and care needs to be taken to avoid further policy mistakes in Western central bank policies. New issues will need to be dealt with. Monetary policy co-ordination and currencies should be one of them. For the inflation forecasting process, there is a need to start again. Milton Friedman’s main insights with a global tweak might be helpful in that rethink.

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