There is an inflation crisis, and some are blaming central banks for following outdated monetarist policies as a response. But forgetting one of the central tenets of monetarism was what led to the current inflation crisis in the first place, argues John Greenwood.

The UK economy is in crisis, and some economists have blamed “the current economics orthodoxy” as being responsible for making it worse. They see the Bank of England’s attempts to regulate demand by raising interest rates, thus making borrowing more expensive, as a relic of failed “monetarist” policies of the past. But this criticism is misdirected.

The setting of interest rates by central banks is only part of a sound monetary policy.  The more important part is to control the growth of the quantity of money. We can see this by noting that high interest rates can be consistent with rapid money growth and high inflation (as in Argentina and Turkey), while low interest rates can be consistent with inadequate money growth and either sub-target inflation or even deflation (as in Japan for most of the past three decades).

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Over the past decade, the Bank of England has gradually shifted away from controlling money - a policy which is fundamental to achieving its mandate of 2% inflation – to placing more and more emphasis on interest rates and monetary/financial conditions indicators. It has ignored money growth. For example, the words “money supply” have not appeared in the Bank’s quarterly Inflation Report since August 2018. The result has been erratic money growth, leading to the current double-digit inflation.

More specifically, the current episode of inflation in the UK has resulted directly from excess growth of the quantity of money since the onset of the Covid-19 pandemic. To verify this simple-sounding statement, we need to show (1) that steady money growth at an appropriate rate was key to the Bank achieving its inflation target in the past, (2) that it was the Bank and not government spending that created the excess money, and (3) that the magnitude of excess money growth is consistent with the amount of inflation generated in the past year or so.

(1)    Steady money growth works in the UK

During the years 2012-19, i.e., the eight years starting with the return of monetary growth to normal after the global financial crisis of 2008-09 and ending just before the onset of the pandemic in 2020, the Bank of England was broadly successful – on average – in achieving its inflation target of 2%. This was despite inflation rising to 5% in 2011 and falling to zero in 2015.

What was the source of that success? Over the period as a whole, broad money growth had averaged 4.4% p.a. In quantitative terms, this had financed average annual nominal GDP growth of 3.8% p.a., while allowing some margin for the annual increase in holdings of money by the population. Research shows this trend of mild increases in money balances to be the norm in both developed and emerging economies and the trend ought to be incorporated into any plan for an appropriate money growth rate. Nominal GDP growth of 3.8% p.a. was split between 2.0% p.a. real GDP growth and 1.8% annual increases in prices, as measured by the GDP deflator.

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As former Governor Mervyn King says, “Quantitative easing is an expansion of the money supply, although most central banks are reluctant to describe it as such.”

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