An old-fashioned way of forecasting inflation — tracking the money supply — still works and should be embraced by the Bank of Canada, argues a new paper from the C.D. Howe Institute.
Université du Québec à Montréal economics professor Steve Ambler and Jeremy Kronick, the Toronto-based think tank’s associate director of research, co-authored the report, which argues for bringing back monetary growth trends as an indicator of inflationary pressures.
Their research finds that tracking the growth in the money supply remains a useful indicator of inflation in both the short and long run, despite having fallen out of favour since the 1980s as central banks embraced inflation targeting.
“We find that the long-run relationship does, indeed, continue to hold, and did so even during the inflation-targeting era,” the report said.
And it argued that, in a period when inflation is deviating far from its target, as it is currently, money supply indicators can help reduce the margin for error in forecasting inflation in the short run.
As a result, they argue that the Bank of Canada “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.”
Their research finds that inflation catches up to accelerating growth in the money supply only gradually over time.
And, given that the money supply grew faster with the onset of the pandemic, more inflation is likely in the cards.
“Four percent of the gap created by a change in trend money growth is eliminated each month, so trend inflation, in the absence of other economic shocks, would catch up in a little over two years,” it said, noting that trend inflation has, so far, closed less than half the gap created by the policy response to the pandemic.
“Money growth rates have come down in recent months, but it will take some time for trend inflation to follow this decrease,” it said. “As a result, the bank will have to work extra diligently to anchor inflation expectations.”
“Accelerating its pace of quantitative tightening and continued forceful communications around the hikes to come should be part of this effort,” the report added.