Monetary aggregates can help increase the accuracy of inflation forecasts. But you shouldn’t overdo it with them either.
One of the laws of economic thinking is that old ideas rarely disappear permanently. Just when they seem almost forgotten, they come back to life. Take monetary aggregates, which in their heyday in the 1970s and 1980s seemed like the holy grail of economic forecasting. Since then, they have steadily fallen out of fashion for many economists. The idea that the general price level of an economy rises when too much money is chasing too few goods is intuitively plausible. Unfortunately, this relationship soon turned out to be quite unstable.
Monetary aggregates provide valuable and early indications that, contrary to many expectations, inflation may prove to be less transitory.
Johannes Müller, Head of Macro Research, DWS
In contrast, practitioners in financial markets, particularly those at the fringes, have never entirely lost faith in monetary numbers to “explain” market developments. The graphic below shows the reasons for this and helps to illustrate the associated dangers. It shows developed equity market prices, as measured by the MSCI World, compared to two broad measures of global M2 growth year-on-year, one including and one excluding China. Intuitively, it looks like stock returns have moved in line with how much more or less money there is in the world right now. It’s no wonder, then, that some who make a living forecasting markets want to keep an eye on the money supply. However, if you look closely, it’s hard to tell which curve leads which other(s). The connection with the inclusion of the Chinese money supply also tends to be closer than without it. This is strange because the MSCI World does not include Chinese stocks. China also relies heavily on capital controls, which have probably been even more difficult to circumvent in recent years due to Covid-related travel restrictions. Compensating for the shrinking money supply in the rest of the world now would require huge numbers of Chinese tourists investing their cash savings across borders.
Global stock prices seem to move in tandem with global money supply – so what?
In short, it’s easy to find correlations that have “worked” well in the past. Especially with something like global money supply, where there are many candidates to choose from which metric seems to fit best for the period under consideration. However, it is unwise to rely on them without a clear understanding of the causal mechanisms and assessments of how and why they may or may not persist in the future. “Nevertheless, we have always looked very closely at monetary aggregates for our inflation forecasts for several large economies, even when it was completely unfashionable,” explains Johannes Müller, Head of Macro Research at DWS. “This provided valuable early evidence that inflation may prove less transient than widely expected.” As a recent paper by employees of the Bank for International Settlements shows, countries with stronger monetary growth in recent years have also experienced significantly higher inflation. This confirms the long-standing belief of DWS specialists that careful use of monetary aggregates in inflation forecasts can sometimes improve accuracy. However, this also underlines why it is better not to explain the markets with “money” alone. From DWS’ point of view, a lot of improvements in the fundamental data are already reflected in the prices on the global stock markets, not least a relatively rapid fall in inflation rates. But it remains to be seen whether this will really happen, also with a view to global money supply aggregates.
Main photo credit: Pixabay
