There’s just no pleasing some people. No sooner had the Bank of Canada executed its latest and most decisive move against inflation – a full percentage point increase in its benchmark interest rate, after two half-point increases earlier this year – than it came under hot fire, from some of the same people who had previously complained it wasn’t doing enough to fight inflation.
I get it: If the bank had raised rates a little sooner, it would not have to raise rates as drastically now. That’s a fair criticism. But it’s a very different criticism than the one that has been the dominant theme among the bank-bashers: that the bank engineered the present high inflation by “printing money,” the better to finance the Trudeau government’s deficits.
The people who make this argument would like you to believe they are citing the teachings of economists. It’s just basic economics, they will say: more money equals higher inflation. In fact that is not basic economics: it is simple-minded economics. What economics actually teaches is that more money equals higher inflation, other things being equal. But in truth other things are rarely equal.
In particular, what the quantitative theory of money says is that, if the demand for money is a constant, then a given increase in the supply of money will give rise to a proportionately large increase in nominal income – enough to generate higher inflation, if it exceeds the economy’s productive capacity.
In the long run that’s a reasonably good approximation: There is a close and well-established relationship between the rate of inflation and the rate of growth of the money supply in the long run. In the short run, however, they are far less correlated, in part because the demand for money is not as predictable as all that.
Worse, neither is the supply. One reason central bankers moved away from targeting monetary aggregates – M1, M2, M2+, in the once familiar series – in the 1980s was that they could neither precisely identify which of the various money measures was the best predictor of inflation, nor, supposing they could, successfully exploit it for policy purposes.
The phenomenon became known as Goodhart’s Law, after the economist and former Bank of England official, Charles Goodhart. It’s sort of the monetary equivalent of Heisenberg’s Uncertainty Principle: The minute you start to target a particular measure of money, it ceases to be useful as a predictor of inflation.
Why? Because financial institutions respond to the constraint by innovating around it, creating assets that, while they do not meet whatever definition of money policy makers might be using, nevertheless have much the same effect.
So instead central banks turned to targeting inflation directly, tweaking interest rates up or down as necessary to keep it within range. It worked well for many years, a period known as the Great Moderation – until first the financial crisis and then the pandemic, when central banks, unable to cut interest rates further, rediscovered the virtues of operating directly on the money supply, buying and selling government bonds in the open market.
These unprecedented interventions were widely predicted to end in hyperinflation. It did not happen. The inflation we are suffering from today, bad as it is, is nothing like what one would expect if one were simply to look at how far and how fast central banks had expanded their balance sheets.
Still, it’s plainly more than central banks expected. It was always clear that that was the risk. While governments were obliged, morally or otherwise, to tide people over through the economic lockdowns they had imposed, and while it made sense, with every government in the world going into debt at the same time, for central banks to help finance the operation in the short term, it was apparent from the start that they would need to move smartly to withdraw the liquidity they had provided, once the lockdown had passed and economies began to recover.
Why, then, were they caught unaware? Perhaps it’s a kind of Goodhart’s Law in reverse. If targeting the money supply causes it to become irrelevant, maybe ignoring the money supply all these years, in favour of inflation targets, has helped to make it relevant again.
So successful had the central banks been through the Great Moderation, three decades in which inflation rarely deviated much above or below 2 per cent, that they conditioned the public to expect inflation would remain there, low and stable, more or less in perpetuity. Inflation expectations, in the jargon of central bankers, were well “anchored.”
That, too, may help to explain why short-term fluctuations in the money supply seemed to have less effect on inflation: People simply looked through them, trusting that central banks would not allow inflation to get much above or below its target, or not for long. Until the twin crises of recent months: the end of the pandemic with its associated pressures on supply chains around the world, and the Russian invasion of Ukraine.
The resulting price shocks were so large as to break the spell central banks had cast over the public. With inflation expectations detached from their 2-per-cent anchor, central banks could no longer afford to take such a leisurely approach to mopping up all the liquidity they had sprayed about during the pandemic.
As the economists Steve Ambler and Jeremy Kronick argue in a recent study for the C.D. Howe Institute, when inflation is locked on target, the target is the best predictor of inflation. But when inflation becomes “unsettled,” the short-term relationship between inflation and the money supply reappears.
It’s true, then, that current inflation was largely set off by supply and commodity shocks. But it became more widespread and persistent than expected because central banks failed to recognize how this had changed the game – that without quiescent expectations helping to tamp down fluctuations in prices, the old verities of monetary policy were about to reassert themselves with a vengeance.
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