UK inflation is judged here to have embarked on a medium-term upswing – see previous post. This view rests partly on the “monetarist” proposition that changes in inflation follow changes in monetary growth with long lag (typically of 1-2 years, according to Friedman and Schwartz). Annual broad money growth, as measured by “non-financial M4” (comprising money holdings of households and private non-financial corporations), has risen significantly since 2011, reaching 6.3% in March, the fastest since 2008.
The chart presents long-run evidence in favour of the proposition that money growth changes reliably lead inflation swings*. The upper panel of the chart show a measure of annual “core” retail price index (RPI) inflation**. The RPI is used because core consumer price inflation data do not extend back before 1997. The bottom panel shows annual non-financial M4 growth.
The labels on the two lines show turning points identified by a numerical procedure (the Bry-Boschan algorithm). There have been 32 turning points in core inflation since 1953, i.e. 16 peaks (odd number labels) and 16 troughs (even numbers).
The procedure identifies 41 turning points in broad money growth over a slightly longer period starting in 1951. The number labels reflect an attempt to pair the inflation turning points with prior or nearby money growth peaks / troughs.
This exercise provides support for the monetarist view that a reliable leading relationship exists. 30 of the 32 inflation turning points have a readily-identifiable money growth counterpart. The only inflation swing that cannot be associated with a money growth move is the minor decline between 2002 and 2005, i.e. points 25 and 26****. The average lead time between money growth turning points and their identified inflation counterparts is 27 months.
There are 11 money growth turning points that have no assigned inflation counterpart, labelled “X”. However, 3 of these occur at the beginning and end of the sample period and should be discarded (because the corresponding inflation turning points are out of range). That leaves 8 “false” signals to explain.
2 of these false signals relate to a rise in broad money growth between 1979 and 1981 that was not followed by an increase in inflation. Most of this rise, however, occurred after the removal in June 1980 of penalties*** on banks’ balance sheet expansion – this resulted in the “reintermediation” of banking business that had been channelled through parallel markets. Narrow money growth, by contrast, fell sharply in 1979-80. These 2 false signals, therefore, are explicable by a distortion to the broad money data.
Of the remaining 6 false signals, 4 relate to small movements in money growth (i.e. in 1994 and 1998-99). While identified by the algorithm, it is doubtful whether an economist analysing the data at the time would have deemed the changes significant.
The results, overall, are encouraging. Money growth appears to have signalled 30 out of 32 inflation turning points, with only 2 significant and unexplained false indications.
What is the current message? Broad money growth made a major low in August 2011, with a suggested corresponding core inflation trough in April 2015. Money growth rose until June 2013, retreating slightly to a low in July 2014 before resuming an increase to a new post-recession high. Based on the average 27-month lead at turning points, the rise since July 2014 suggests that core inflation will be on an upward trend from late 2016, with no peak until mid-2018 at the earliest.
*A longer research note is available on request.
**Core inflation is used because headline inflation is regularly “shocked” by influences unrelated to domestic monetary conditions, such as global commodity price swings and changes in indirect taxes and administered prices. The core RPI definition here excludes mortgage interest, food, alcohol, tobacco, fuel & light, petrol & oil, council tax / rates and housing depreciation, and adjusts for VAT changes in July 1979, April 1991, December 2008, January 2010 and January 2011, and the change in undergraduate tuition fees over 2012-14.
***The supplementary special deposits scheme, known as the “corset”.
****Core CPI inflation was stable over this period.