The ECB could influence the money supply sufficiently in the long term.
(Photo: dpa)
Inflation is rising, as is the money supply – many investors see a connection and fear persistently high inflation. But most economists disagree. They banned the money supply from their models years ago. It was probably too radical. Because the money supply is way better than its reputation.
The critics of the money supply rightly point out that money is not only used to buy goods and services, but is also hoarded in accounts. This happens especially in times of crisis, which is why money then circulates more slowly in the economy and a short-term increase in the money supply does not lead to more inflation.
But if the money supply increases too much over longer phases, that is still inflationary. If a trend is distilled out of the money supply, it still says a lot about the basic direction of inflation.
We saw it with the opposite sign in the years before the pandemic. Because the money supply grew by just under five percent on average, inflation fell short of the European Central Bank’s (ECB) target of two percent.
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Another objection to the money supply is that the central bank cannot control it. That’s right, because the banks first decide how many loans to grant and then credit their customers’ current accounts with new money.
ECB can influence the money supply
But the ECB can significantly ensure appropriate lending rates with its key interest rate. Bank customers then do not ask for too much credit and there is not too much new money. The ECB can sufficiently influence the money supply in the long term.
Jörg Krämer is chief economist at Commerzbank.
(Photo: Commerzbank)
Sometimes she even controls them directly. If, as has been the case since the beginning of the pandemic, it finances the entire budget deficits in the euro area by buying government bonds, this additional money ends up in the accounts of the finance ministers, who spend it and thus circulate it.
When judging the money supply, the alternative must also be considered, namely aligning monetary policy directly with the ultimate goal of low inflation and ignoring the money supply as an intermediate goal. But such direct inflation control is also associated with risks. US inflation initially fell after the outbreak of Corona and gave the all-clear.
But the massive increase in money supply signaled early on that the former US President Donald Trump, flanked by the bond purchases by the US Federal Reserve, was granting financial aid that was far too lavish. The inflated demand met with a corona-related drop in supply and caused inflation to skyrocket.
Ultimately, the alignment of monetary policy with the money supply as well as inflation forecasts has strengths and weaknesses. But ignoring the money supply is radical and could soon prove to be a mistake.
Jörg Krämer is Commerzbank’s chief economist.
More: Is high inflation really just a temporary phenomenon? A pros and cons.