Money supply growth is adding hidden pressure on inflation.
Investors are likely underestimating how much the Bank of Canada will raise interest rates because they are overlooking money-supply growth that is putting hidden upward pressure on inflation, according to former central bank researchers.
Former BOC analyst and associate research director at C.D. Howe Institute Jeremy Kronick told MNI in a phone interview on Monday that money supply is a reason the central bank has consistently under-estimated the post-Covid-19 inflation rise. The trend growth of money has climbed 1.5 percentage points since the pandemic, about double the inflation trend, and it will take about two years for prices to catch up.
“This is one of those things that will have to be dealt with above and beyond things like the war, supply chain issues,” Kronick said. “Perhaps we’re even under-estimating how much work it is going to take to get it back down” he said, referring to inflation.
Governor Tiff Macklem has said the chances of him raising the 1.5% overnight rate beyond the neutral range of 2%-3% are growing because rapid inflation could become entrenched. Most economists see the Bank hiking 75 basis points on July 13, which would be the biggest since a 1 percentage point move in 1998. Views of what happens after July diverge as some economists see the cycle ending within the neutral range at 2.75% and others predicting a 3.5% rate by year-end.
KEEP THINKING HIGHER
Few economists appear to have added the money supply effect into forecasts of how long or steep the rate increase path will be, Kronick said. “Whatever you think it is, if your models aren’t taking the money growth angle into perspective, it may have to go even higher, because inflation may not come down as quickly as you think.”
Clement Gignac, a Senator who helps oversee the Bank through a parliamentary committee, has also told MNI that a bolder tightening may be needed to get inflation under control, and an outside research fellow has said inflation may quicken in the near term.
Macklem should also consider more aggressive quantitative tightening according to a paper Kronick wrote with former BOC adviser Steve Ambler for C.D. Howe, which runs a shadow monetary policy council. The Bank current stance is allowing maturing assets to roll off its balance sheet, a process that will take several years.
Policymakers instead could act "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," Kronick and Ambler wrote in the paper officially being released Tuesday morning.
TOUGHER QUANTITATIVE TIGHTENING NEEDED
Part of the Bank's hesitancy around stronger QT may be the lack of experience with such operations, Kronick said. Canada avoided major asset purchases used by other major central banks in during the global financial crisis around 2009.
There is a similar logic around a lack of recent history to guide big rate hikes, he argued.
“When was the last time we had a severe tightening cycle like this, 30, 40 years ago, so there’s not a lot of experience out there,” he said. “You might see inflation at 7% for a number of months, and there then might be an additional need to keep rates on their onward march.”
The link between money supply and inflation appeared to fade out in the 1990s when the Bank enshrined and upheld a 2% inflation target, the researchers found, but it has become more prominent again with the recent jump in prices.
“Money talks and what it’s predicting for inflation is not encouraging,” co-author Ambler wrote in the paper.