from TD Economics

Highlights

• There was a time not too long ago when money supply was central to economists’ expectations for inflation. While a long-term relationship between the two variables has never been in doubt, monetary aggregates have done little to explain short-term movements in inflation over the past several decades.
• History has shown that sustained high rates of inflation cannot occur without excessive money growth. The policy response to the pandemic created such a significant surge in money growth that it may have pushed the long-term relationship into the short-term.
• Our analysis shows that including money supply in a statistical model for inflation can improve its performance. While this improvement falls to effectively zero over the inflation targeting period prior to the pandemic (1992-2019), it returns in the pandemic and post-pandemic period.
• After surging in 2020, money supply is now in retreat. This does not mean that the economy is susceptible to a bout of deflation – economic conditions and inflation expectations still matter. Instead, it should contribute to confidence that the Bank of Canada has taken the steps necessary to return inflation to its 2% target.

The sharp acceleration in money supply and inflation in the aftermath of the pandemic has reignited a debate over the direct role money plays in driving faster price growth. Central banks once paid close attention to money supply. From 1975 to 1982, the Bank of Canada (BoC) directly targeted growth of M1 – a monetary aggregate consisting of currency and bank chequable deposits.

The Bank of Canada has long since moved away from targeting money supply as an intermediate step in controlling inflation, opting for direct numerical inflation targets. While the central bank has largely removed money from its lexicon, ignoring it completely has its downsides.

Empirical analysis shows a persistent long-run relationship between money supply and inflation that has stood the test of time. In certain circumstances, it can also be helpful in explaining shorter-term movements. Inflation’s relationship with money supply is most evident in situations in which price growth has been pushed out of its narrow “low-and stable” corridor. 

A forecasting approach that includes the typical drivers of inflation, as well as money supply suggests that the surge in money supply that contributed to its acceleration will now be helpful in moving it back to target. By removing some of the extensive liquidity provided to the economy in the aftermath of the pandemic, the Bank of Canada is showing its commitment to its 2% target and the policy actions necessary to attain it.

Source: TD Economics