Wave of money points to looming pressure on RBA to lift rates

The Australian 12:00am July 12, 2017

Adam Creighton

A wave of inflation is about to wash over Australia, compelling the Reserve Bank to lift interest rates, if the long forgotten, but reliable, link between increases in prices of goods and services and changes in the quantity of money in circulation still holds true.

A trio of economists, including Malcolm Turnbull’s current economics adviser, have produced provocative research showing that the growth rate of the money supply — the value of notes, coins and bank deposits — is galloping ahead of economic activity, with the potential to compel the Reserve Bank to lift rates.

“If a gap like this remains we could be facing 3 per cent-plus inflation in two or three years, the top of the RBA’s band,” said Griffith University economics professor Tony Makin.

The excess of the growth of the value of money and at-call bank deposits in Australia over the rate of increase of the consumer price index has widened to the highest level since the 1970s, according to research forthcoming in the eminent journal Economic Modelling.

It would be “a big challenge for central banks to check inflation” if these historical relationships still held true, Professor Makin said.

“I feel all that theory and evidence of the past can’t be wrong and there must be bottled-up inflation,” he added, referring to the once famous Quantity Theory of Money that posited a direct link between money and prices.

The Reserve Bank, which aims to keep inflation between 2 per cent and 3 per cent, expects underlying inflation (which strips out volatile items) to rise from 1.75 per cent over the year to June this year to 2.5 per cent by 2019 as the economy improves. Its latest statement on monetary policy makes no mention of the money supply, which increased 7.5 per cent to $351 billion over the year to May.

Professor Makin, along with the Prime Minister’s senior economics adviser, Alex Robson, and Shyama Ratnasiri, found the relationship between Australia’s inflation rate and “excess currency” growth (defined as money growth minus GDP growth) had gone from near one to one before the early 1990s to a correlation of just over 40 per cent since then.

“It’s not as strong as it used to be but it’s still pretty strong,” Professor Makin said. The Reserve Bank and other major central banks introduced “inflation targeting” by setting an official interest rate in the early 1990s, after failed attempts in the 1980s to control inflation by controlling the money supply directly.

“Excess money growth has been the key determinant of Australia’s past inflation (even if) the switch to inflation targeting in the early 1990s has been highly successful in keeping inflation low,” the study said. Professor Makin said: “Nobody talks about it any more; I remember years ago, I published a paper for the CIS policy that just plotted currency and inflation and showed they were very close.”

A lack of inflation in advanced countries — despite ultra-low interest rates and massive monetary stimulus in the US, Britain, Japan and Europe — has puzzled economists around the world since the global financial crisis.

US economist Milton Friedman in the 1960s famously said “inflation was always and everywhere a monetary phenomenon”, a view at odds with followers of British economist John Maynard Keynes, who believed “aggregate demand” and “aggregate supply” were more important factors.

“Early empirical studies of the determinants of inflation found that the classic Quantity Theory of Money that Milton Friedman revived, and which can be traced back to Roman times, David Hume in 1748 and Irving Fisher 1911 among others, has best explained inflation over the long run,” the study said.

Their forthcoming paper, “Missing money found causing Australia’s inflation”, found that the link between inflation and a broader definition of money that includes term deposits (known as M3) had broken down since the 1990s.

“This may be because the traditional medium of exchange role that currency, a very narrow monetary aggregate, plays has diminished due to financial innovation,” they concluded.