From the number of articles lined up on both sides it is clear that this is not one that can easily be answered. Here is one take - although there is a very misleading "error" right at the beginning, the points being made need to be analysed (critically) in order to have some understanding of both sides of the argument:
ANALYSIS (PHILIP PILKINGTON)
Are central bankers fighting the last war?
Some economists point to a falling money supply as a harbinger of recession and a period of deflation. They have got it wrong, says Philip Pilkington. Expect protracted stagflation instead
Ascentral banks fret over inflation, a small number of contrarian but influential economists are saying that the central bankers have it all wrong. They argue that by tightening interest rates the central banks are fighting the last war and that the real threat to the economy is, in fact, deflation. They foresee a large recession ahead that will lead to falling prices and living standards.
The economists who espouse these views are associated with the monetarist school, which came to prominence in the 1960s and 1970s through the work of Milton Friedman. The school teaches that inflation is caused by excess growth in money supply – the amount of currency and other liquid assets circulating in the economy. “Inflation,” Friedman famously wrote, “is always and everywhere a monetary phenomenon.”
The idea is simple enough. Monetarists believe that the money supply is controlled by central-bank policy. By flooding the banking system with monetary reserves, the central bank increases lending as these reserves are released as loans into the economy. When central banks shrink the reserves in the banking system by selling government bonds to soak up the reserves, as central banks are now doing as part of their monetary tightening, the loan books of the banks contract and the money supply decreases.
Monetarists believe that movements in the money supply precede movements in prices. So, if we see a shrinking money supply now, we should expect falling prices and possibly a recession soon. This is why the monetarists believe that they know something that the central banks do not: they are laser-focused on their money-supply measures, while the central banks are still looking at inflation metrics.
MONETARISM IS BROKEN
One might be forgiven for assuming some arrogance on the part of the monetarists. Far be it from me to think that economists working at central banks always get things right. But the people who work at these institutions are well versed in macroeconomics. If there were a single metric that could reliably predict the swings in inflation and had been widely discussed by famous economists since the 1960s, it is hard not to think that the central banks would pay more attention.
The truth is, however, that monetarism does not work. Money-supply metrics can be interesting, as part of a broader basket of leading economic indicators. But they are far from perfect. In the 1980s, the Bank of England tried to use monetarist theory to steer the economy, but it soon abandoned this after it realised it did not work as advertised.
“STAGFLATION IS PRECIPITATED BY A SUPPLY SHOCK, SUCH AS OPEC WITHHOLDING OIL IN THE 1970S”
In the case of the United Kingdom, there is simply no debate. The M3 money supply metric is the broadest gauge of the money supply. It comprises the currency in circulation, deposits with a maturity of up to two years, deposits redeemable at notice of up to three months, repurchase agreements, money market fund shares, and debt securities of up to two years. A chart going back to 1988 shows that M3 does not seem to have any meaningful, reliable relationship to inflation (measured by the consumer price index). In a US chart going back to 1960 we do see some correlation, sometimes, but it is not remotely reliable. The reason central banks do not use money-supply metrics alone to forecast the path of future inflation is because they have looked at this data and drawn the obvious conclusion that it does not work.
This is why the Bank of England continues to raise rates. Some prominent monetarist-inspired commentators are saying that the rate hikes are now going too far. They point to the falling money-supply growth and say that a recession is on its way. It follows from this that any further rate hikes are harmful. They are not needed to get inflation down – because, monetarists say, inflation will follow the money supply – and they will only produce a deeper recession.
When faced with this argument, the economists at the Bank of England are not moved. They know that the money supply metrics are not a reliable future predictor of inflation. So they keep hiking, as they can no longer allow inflation to run rampant. Their position, in this regard, is perfectly reasonable.
GROWTH, INFLATION, OR STAGNATION?
Another argument made by the deflationists is that world growth is contracting. Proponents of this view point to the obvious stagnation in the developed countries and the failure of the much-vaunted Chinese reopening. There is no doubt that developed economies are mired in stagnation. But the deflationistas seem to be confusing growth and inflation.
In normal times, growth and inflation move in lockstep. When the economy starts growing too quickly, we see inflation. When we see the economy slow, we see deflation. But the current stagnation is accompanied by very high inflation. What we have been experiencing for the past two years is stagflation, the combination of economic stagnation and inflation. We had a bout in the 1970s, too.
Stagflation has several interlocking causes. The precipitating factor is almost always a supply shock: a random event that negatively affects the supply side of the economy. In the 1970s, the supply shock was the Opec oil cartel withholding supplies from global markets in response to US support of Israel in the 1973 Yom Kippur War. Today, the supply shock is a combination of the supply-chain disruptions caused by the lockdowns, together with the disruption to energy and fertiliser markets due to the war in Ukraine.
After the initial supply shock, stagflation is carried forward by rising wages. Workers get angry that the prices of goods have risen and so they demand higher wages. These wages are then passed on to consumers in the form of rising prices and so inflation gets worse. We end up in a vicious spiral, which economists call a wage-price spiral. The problem today is that the low growth – which is giving rise to interminable “recession-watching” – is coupled with high inflation.
It is true that the Chinese recovery has disappointed. Growth in services in the country have been robust, but the manufacturing sector has lagged. This is because the Chinese government hoped that consumption would pick up the slack so that the economy would no longer have to rely on very large amounts of investment. In past cycles when consumption growth has failed to materialise, however, the Chinese government has turned back on the investment tap to hit its growth targets. Expect a repeat performance in the coming months.
“A REAL RECESSION DOES NOT OCCUR UNTIL PEOPLE ARE LOSING THEIR JOBS”
This raises the prospects of an inflationary recession. The deflationists may be correct that the developed economies may be about to tip into recession. But it does not follow from this that the recession will be accompanied by falling prices. Price pressures may well stick around. The destabilisation of supply chains associated with the war in Ukraine has not gone away. European gas prices, for example, remain high because we have replaced cheap piped Russian gas with liquefied natural gas (LNG), which costs about 40% more. The situation with fertilisers will not get any better simply due to a recession, and so food prices may remain high.
Then there is the wild card of China. If the government increases investment to meet its growth targets, we may see a “two-track” world economy emerge, with China bolstering growth in developing economies while developed ones slip into recession. If this happens, energy prices are unlikely to fall very far as these countries prop up demand. That may mean even higher prices in developed economies, regardless of how deep the recession turns out to be.
An inflationary recession
How will we know if the dreaded inflationary recession takes place? The first indicator to look out for will be rising unemployment. There has been much discussion of “technical recessions” these past few months. But these definitions are not helpful. A real recession does not occur until people are losing their jobs. When we see unemployment start to tick up – most likely to be led by lay-offs in the construction sector – we can say for sure that the recession has arrived.
At that stage, we will have to keep a close eye on inflation. In an inflationary recession, the rate of inflation will slow. But it will remain higher than it does in a typical recession. For example, during the depths of the 2009 recession in the US, inflation fell at a rate of -1.5%. In an inflationary recession we would expect that either inflation keeps rising at 2%-3%, or that it dips but then takes off quickly after the recovery begins and outstrips the central bank’s 2% target.
At present the prospect of an inflationary recession seems more likely than deflation – or at least sustained deflation. Stagflation hits when there is turmoil in the world that starts to affect the economy. The 2020s have seen an excessive amount of turmoil so far, and there are still enormous risks in the global system, the most notable being the prospect of a trade war – or even an actual war – between the US and China. Either would be catastrophic for the global economy and immediately set off inflation far worse than anything we have seen so far.
But even if the tension between China and the US ebbs, there are plenty of factors that point to structural price pressures. A recession may well drive cyclical inflation down temporarily as workers are laid off and wages fall, but it seems perfectly possible that the structural features will eventually overwhelm the cyclical ones and, after a brief lull, inflation will come back on the menu.
That is what we saw last time we had stagflation. In the recessions of 1970 and 1973-1974, inflation started coming down, but then shot right back up as the economy recovered. This explains why central banks want to hammer a stake through the heart of inflation. If the inflationary monster were to revive after a recession, it would be nothing short of disastrous.
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