Money Talks: The Old, New Tool for Predicting Inflation

July 5, 2022

With inflation on the rise, the Bank of Canada should re-examine the link between growth in the money supply and future inflation, according to a new report from the C.D. Howe Institute. In “Money Talks: The Old, New Tool for Predicting Inflation,” authors Steve Ambler and Jeremy Kronick show that tracking growth in the money supply, from cash and bank accounts to savings bonds and more, is a useful predictor of inflation in the short and long run. “Money talks and what it’s predicting for inflation is not encouraging,” says co-author Ambler.

Canadian money supply grew in 2020 and 2021 at unprecedentedly high rates, inflation is now nearly 6 percentage points above the 2 percent target, and measures of inflation expectations show that inflation is not expected to return to target within the Bank of Canada’s usual planning horizon of six to eight quarters.

By examining “trend” money growth (screening out short-term fluctuations over time), now 1.5 percentage points above where its value was prior to the pandemic, and “trend” inflation not quite half of that, the study indicates we are not done with price growth yet, meaning the Bank will have to work diligently to anchor inflation expectations.

In their research, the authors answer two questions. First, is there still a long-run relationship between monetary aggregates and inflation despite the disappearance of the short-run relationship starting in the 1980s?

“We find that the long-run relationship does, indeed, continue to hold, and did so even during the inflation-targeting era,” state the authors.

Second, if in the short run the relationship disappeared due to the success of inflation targeting by the central bank, when the regime is not operating as expected does this relationship return? “The target itself is the best predictor of inflation in an inflation-targeting regime when the central bank is keeping inflation close to its target,” says Ambler. But the authors find that in periods when inflation deviates substantially from target, keeping track of money does often reduce the margin of error in forecasting inflation.

Their conclusions have significant policy implications for the conduct of monetary policy. “The Bank should monitor trend monetary growth more closely and track deviations of trend money growth from trend inflation, in particular when inflation is unsettled, as it is now,” concludes Kronick.