The Old Monetarist Dog is Not Dead Yet

The Bank of England has come under a lot of flak, and rightfully so. Its failure to predict today's persistent inflation has now left households with a sour taste in their mouths as interest rate pain trickles throughout the economy.  Such an outcome makes one wonder, how did the Bank of England get it so wrong? And, more importantly, how can it do better in future?

The Bank’s predominant understanding of inflation and subsequent interest rate adjustments emanates from the New Keynesian consensus. Central to this is NAIRU (Non-Accelerating Inflation Rate of Unemployment), an idea thought of by Milton Friedman himself. NAIRU represents a state where unemployment does not cause inflation to increase or decrease. When actual unemployment falls below NAIRU, inflation typically accelerates, prompting the Bank to raise interest rates. 

The Taylor Rule integrates NAIRU into its formula but the way it does so is by looking at the potential output of the economy. The Taylor Rule acts as a compass for central banks to set short-term interest rates based on current inflation rates, desired inflation targets, and the gap between actual GDP and potential GDP. Effectively, while NAIRU gives our ‘potential output,’ the Taylor Rule is the logical process that spits out the desired policy rate based on where current factors compare to NAIRU.

While the Taylor Rule provides a neat mathematical model, central banks, including the Bank of England, must be wary of sudden, transient shocks to inflation rates. Swift responses to every fluctuation can cause unnecessary volatility in interest rates, destabilising the economy and, most importantly, reducing the credibility of the monetary policy regime. This cautionary mindset made the Bank overlook the inflationary ramifications of the Russian war in Ukraine. They presumed it to be a temporary blip on the inflation radar, failing to understand that inflation was not fleeting. 

But how could such a huge policy institution like the Bank of England fail to realise inflation was in fact, not transitory? While the Bank does try to use a range of models, none of these give money growth the weighting it deserves. In these models, the money supply is passively determined by a money demand function. Private banks create 80% of the money in a modern economy and it is a modern myth that these banks lend out savings.

Instead, when making a loan, private banks effectively create new money out of thin air by adding the value of new loans to their assets while also adding new deposits to their liabilities to balance the books. This means that banks can effectively lend unlimited quantities of money with two binding constraints being; whether there is someone to lend to, and, if the interest earned on the loan is higher than the interest paid to the central bank (the profit margin). For this reason, the consensus argues that, because banks can lend unlimited quantities of money, demand creates supply - not the other way around. 

However, this line of thinking has a huge limitation; it does not consider the impact of quantitative easing on money demand.  Yes, while banks and financial institutions only create money if firms or individuals ask for said money via lending, unconventional monetary policies such as QE can artificially raise this money demand. QE creates portfolio rebalancing problems for pension funds which then raises asset prices, therefore increasing demand for loans (money) as firms see improved gearing ratios. With this, we can see that the money supply is not purely based on money demand because the demand for money itself can be externally influenced by the Bank of England. 

Empirically, when inflation is already high, 95 per cent of inflationary spikes can be attributed to surging money growth. Yet, central banks across the board still choose to ignore money growth and prefer using expectations. Even now, with money growth on a near-negative trajectory, some Bank economists believe that increasing tightening is necessary because of tight labour markets and rising expectations. Unless we plan on jumping into recession, such thinking has to change. 

The Bank must reevaluate its stance on how QE influences money demand, and, in turn, the growth of money. The current crisis highlights the limitations of relying solely on the Bank's four New Keynesian economic models. To navigate such intricate terrains more effectively, the Bank should consider integrating a fifth money demand model which pairs the aforementioned relationship between QE and money demand with forecasts detailing the composition of the money supply. 

This refined approach could rectify past oversights, like during the Global Financial Crisis and the COVID pandemic, where policymakers assumed that QE doesn't lead to inflation. The reality is nuanced: inflation arises when QE's liquidity benefits consumers and firms through accessible lending. Without composition analysis, we risk misinterpreting the true effects of QE, as much of the added liquidity in past crises remained trapped within the financial sector.

The benefits of this model would be twofold. First, it can run parallel to existing models, offering the bank opportunities for deeper discussion if New Keynesian models contradict their monetarist alternatives. Second, its use would also signal a departure from our current modelling approach into a new era where models with opposing ideas can coexist to create discussion and refine policy. 

For those wondering whether the Bank would use such a radical approach, a quick look at the August Monetary Policy Report shows the use of a money supply growth chart by the Bank of England itself. After all this time, it seems as though the old Monetarist dog is not dead yet, and its revival signals the Bank’s departure from its outdated groupthink culture.

All articles and opinions posted give the views of the author(s) and do not necessarily reflect the views of the Leeds Think Tank, the Leeds University Union, or the University of Leeds.