Money Talks : The Old, New Tool for Predicting Inflation

With rising inflation top-of-mind for Canadians, a major question is: Can we predict its future? This Commentary shows that growth in the money supply is a useful predictor of inflation, and examines why and when.Since the early 1990s, the Bank of Canada has pursued a successful inflation-targeting strategy. With inflation, and inflation expectations, safely anchored in the Bank’s target 1-3 percent band, tracking the growth of money supply in the economy as an aid in forecasting inflation fell out of fashion. In this Commentary, we examine both the short- and long-run relationship between money supply growth and inflation and find both matter for monetary policy.Our results have important implications for the analysis of monetary policy and inflation during the current pandemic period. 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.This paper answers two questions:- Is there still a long-run relationship between monetary aggregates and inflation despite the disappearance of the short-run relationship starting in the 1980s?- If the main (but not only) explanation for the disappearance of the short-run relationship is the fact that the target itself is the best predictor of inflation in an inflation-targeting regime, then when the regime is not operating as expected does the short-run relationship return?We find that the long-run relationship does, indeed, continue to hold, and did so even during the inflation-targeting era. We also find that keeping track of money does often reduce the margin of error in forecasting inflation when the latter deviates substantially away from target, as it does today.With “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, we are not done with price growth yet, meaning the Bank will have to work extra diligently to anchor inflation expectations. Accelerating its pace of quantitative tightening (QT) by reducing the oversized quantity of bonds on its balance sheet and continued forceful communications around the hikes to come should be part of this effort