Money Supply, Inflation, and the Emperor’s (i.e., Central Banker’s) Nakedness

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The Financial Times on Monday had two stories on inflation, one a lengthy story, the other a a comment, “The problem with inflation indices,” by Gideon Munchau, triggered by the fact that the Bank of England missed its inflation targets of 2% by over a percentage point (their Consumer Price Index increased at an annualized rate of 3.1% in March. That may not seem noteworthy, but because the increase was in excess of 1%, it required the bank’s governor to issue a letter of explanation to the chancellor, for the first time since this rule was put in place in 1997.

Munchau focuses on something we have discussed before, namely, the fact that inflation indexes (along with other government statistics) too often fail to serve their purpose (often because they have been compromised for political reasons):

But the problem of a persistent gap between a central bank’s target price index and a separate measure used by the public has recently become more acute in the UK and the US. The Bank of England targets the so-called consumer price index, while most people in the UK sensibly rely on the old retail price index, which gives a far truer picture of the cost of living including housing. Both indices have registered increases recently. But whereas the CPI has most recently grown at an annual rate of 3.1 per cent, the RPI has gone up by close to 5 per cent. The gap between the two is large and persistent. When that happens, a central bank has a problem. On a recent visit to South Korea, I was told that the same was happening there: prices were rising everywhere, yet the price index gives the illusion of price stability….

The Federal Reserve follows a reasonably well-behaved core inflation index, yet this index has become totally irrelevant for middle-class families* who spend most of their income on items such as education and healthcare, where cost inflation has exploded. While the official indicators are extremelyconvenient for policymakers, nobody in their right mind would rely on a measure that persistently misjudges what 21st century families spend their money on.

Munchau argues for using a broader measure of inflation; I wonder why no one uses the GDP deflator (well, we Americans can’t because our GDP figures are already massaged to a considerable degree).

The problems in measuring inflation are well known. What I found troubling was the discussion in the FT’s analysis, “Winds of change,” of money supply:

Some economists blame the price surge on the Bank’s lack of regard for the growth of money slushing around the economy. The UK measure of broad money in the economy, M4, grew by 12.8 per cent in the year to March, prompting a group of academics, including Charles Goodhart, a former chief economist of the Bank of England, to write to the FT expressing alarm that “unless the annual growth rates of money and credit fall to appreciably lower levels, there is a high risk of above-target inflation in 2008 and even in 2009”.

The ever precise Mr [Mervyn] King [Bank of England governor] has some sympathy with this argument. But as he explained to the FT, the key to understanding money’s role is to distinguish accurately between dangerous increases in the supply of money and manageable rises in the demand for money….

The problem is that measures of money in a modern economy are the result of both supply and demand, and distinguishing between the two is fiendishly difficult. Most economists think the current rapid rise in money in the economy is really the result of changes in the demand for money, just as when an easterly wind used to blow across London, bringing the ships to port.

So, rather than the inflation problem being the result of money, the consensus of opinion believes other forces are at work. Part of the increase is a benign temporary blip, caused by unexpected spikes in the prices of energy and food commodities, which will settle back. The proponents of this view, including Gordon Brown, the chancellor and prime-minister-in-waiting, believe inflation is poised to fall sharply, starting tomorrow when the inflation figures for April are published.

But the other part of the increase in prices, economists believe, is more permanent, namely, that demand and spending has run ahead of the economy’s capacity to meet it without prices rising.

Let me make this all a good deal simpler. Back in the early 1980s, Federal Reserve Chairman Paul Volcker conducted a unpopular and ultimately very successful experiment, using money supply targets to get inflation under control. Now the world was admittedly much simpler then. Banks were much more important financial intermediaries than the capital markets, and the many forms of near money and other innovations like derivatives were yet to come.

Yet with all these changes and complexities, no one would deny today that money matters. But the discussion in the FT is the most bare-faced admission I have seen that no one has the foggiest idea of what to make of money supply these days.

There’s an old joke that regulators drive looking in their rear view mirror. It’s now official: not only do central bankers also rely on the rear view mirror, but in addition, their speedometer is broken.

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