EcoWeek

After disconnecting, will money supply growth and inflation reconnect?

Eco week 21-13 // 2 April 2021  
economic-research.bnpparibas.com  
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EDITORIAL  
AFTER DISCONNECTING, WILL MONEY SUPPLY GROWTH AND INFLATION RECONNECT?  
Since the Great Recession, the monetary base in several advanced economies has seen a considerable increase, driven  
by the creation of bank reserves at the central bank. Yet, contrary to what had been observed in previous decades,  
this has not been followed by a significant pick-up of inflation. Following the global financial crisis, the demand of  
the banking system for central bank reserves increased a lot. This was a reflection of the dire state of the economy  
and money markets as well as tighter liquidity requirements. Subsequently, quantitative easing caused an increase  
in reserves on the initiative of the central bank. Going forward, as the economy strengthens, money supply growth  
and inflation could reconnect on the back of an increase in money velocity or faster credit demand growth. Central  
banks have the tools to address this, if need be. Clearly, asset markets might be less relaxed about such a prospect.  
Why has the massive expansion of central bank balance sheets in In the aftermath of the global financial crisis in 2008-2009, money  
advanced economies not succeeded in lifting inflation? It’s a frequently markets were no longer functioning smoothly and many banks were  
asked question that reflects a feeling that an increase in the monetary facing pressures on liquidity, so central banks reacted by supplying  
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base and broader money aggregates will inevitably lead to higher abundant reserves: “the expansion in base money was instrumental in  
inflation.  
avoiding fire sales and a curtailment of credit with potentially severe  
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consequences for the real economy” . The demand of banks for central  
This view may be based on common sense: in a fiat-based monetary  
system, money is created ‘out of nothing’ so when a lot of it is created  
and used to buy goods, it may lead to more inflation. It could also be  
based on reading about hyperinflation in the Weimar republic or, more  
recently, in certain developing economies. Economists have learned at  
school about Milton Friedman’s observation in 1970 that “Inflation is  
always and everywhere a monetary phenomenon in the sense that it  
is and can be produced only by a more rapid increase in the quantity  
bank reserves did not reflect gathering strength of the economy and  
credit demand, rather it was a manifestation of considerable uncertainty  
about the outlook, economic weakness, a poorly functioning interbank  
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market and new regulations in terms of liquidity .  
US MONEY SUPPLY AND INFLATION  
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of money than in output.” This was confirmed by empirical research  
conducted by the 1995 Nobel Prize winner Robert Lucas: “The prediction  
that prices respond proportionally to changes in money in the long run  
Monetary base, y/y %  
CPI, y/y % (rhs)  
Money supply M2, y/y %  
has received ample — I would say, decisive — confirmation in data  
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from many times and places.”  
120  
100  
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Things have evolved since the mid-nineties and the huge increase in  
the monetary base in the United States, Japan and the euro area since  
the Great Recession has not been followed by a significant increase  
of inflation. In explaining this disconnect, the origin of the creation  
of reserves plays a key role. In normal times, the growth of central  
bank reserves is determined by the demand by banks, which in turn  
depends on the evolution of banks’ short-term liabilities (deposits and  
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3
0
2
8
6
4
2
0
0
0
0
0
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debt securities with a residual maturity of up to two years) . For the  
banking system as a whole, the growth of deposits is largely driven by  
the growth of bank credit (‘loans create deposits’), which means that  
the money multiplier –the ratio of broader monetary aggregates to the  
monetary base– is rather stable.  
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20  
-3  
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0 64 68 72 76 80 84 88 92 96 00 04 08 12 16 20  
SOURCE: FEDERAL RESERVE, BLS, BNP PARIBAS  
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.
The monetary base, also called base money, corresponds to notes and coins in  
circulation and bank reserves held at the central bank.  
Robert E. Lucas Jr., Monetary neutrality, Nobel Prize Lecture, December 7, 1995,  
Base money, broad money and the APP,” ECB Economic Bulletin, Issue n° 6, 2017.  
5. ECB (2017)  
6. This concerns the Liquidity Coverage Ratio. Before its introduction, bank reserves more  
or less corresponded to the reserves that banks were required to hold at the central  
bank. Reserves held by banks at the central bank increased significantly following the  
introduction of the LCR. “The objective of the LCR is to promote the short-term resilience  
of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate  
4.  
Money supply growth and inflation can reconnect but for  
inflation to spin out of control, it would require central banks  
to acquiesce this.  
The bank  
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Eco week 21-13 // 2 April 2021  
economic-research.bnpparibas.com  
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The same happened in the US: “banks would rather hold reserves  
safely at the Fed instead of lending them out in a struggling economy  
EURO AREA: MONEY SUPPLY AND INFLATION  
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loaded with risk . The opportunity cost of holding reserves is low, while  
the risks in lending or investing in other assets seem high. Thus, at  
near zero rates, demand for reserves can be extremely elastic.”8  
Monetary base, y/y %  
HICP, y/y % (rhs)  
Money supply M3, y/y %  
In addition, the introduction of quantitative easing caused a supply-  
led increase in bank reserves as well as in bank deposits. When a  
central bank conducts asset purchases, banks act as an intermediary  
between the central bank and the owner of the bonds which are  
bought, giving rise to an increase of the assets (reserves) and liabilities  
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3
2
1
0
0
0
0
0
0
0
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(
client deposits) of banks’ balance sheets. Reserves are injected in the  
banking system on the initiative of the central bank, which is able to  
do so by paying a sufficiently attractive price for the assets it wishes  
to acquire. The creation of reserves via QE has, at its origin, nothing  
to do with increased credit demand. To stimulate economic growth,  
QE seeks to trigger a variety of transmission mechanism: confidence  
effects, signalling effects –‘current policy rates will be maintained for  
a long time’-, declining government bond yields via a reduction in the  
term premium, lower corporate bond spreads, wealth effects, a weaker  
currency. It can also stimulate banks to extend more credit to increase  
their return on assets, which have increased due to QE. Many of these  
channels only have a very indirect influence on growth and inflation,  
and provide a monetary explanation for the very loose relationship  
between money supply and price developments.  
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10  
20  
30  
0
-1  
9
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01  
03  
05  
07  
09  
11  
13  
15  
17  
19  
21  
SOURCES: ECB, EUROSTAT, BNP PARIBAS  
Should one be concerned about the possibility that these two variables  
would reconnect? No, quite to the contrary, such a development  
should be welcomed. It would mean that economic agents would use  
their deposits to finance spending, so money would circulate more  
quickly. This increase in money velocity would be testimony to a better  
economic environment and outlook. Should this cause somewhat  
higher inflation, central banks would be relieved as well, given where  
they currently are versus their inflation target. An improving economy  
could also boost credit demand, which well-capitalised banks would  
be happy to meet considering their high level of excess reserves at the  
central bank. If this would end up creating concern about too quick an  
increase in inflation, central banks would be well-equipped to address  
it by using forward guidance, hiking their deposit rate or draining  
liquidity by shrinking their balance sheet. Clearly, asset markets might  
be less relaxed about such a prospect. After all, the disconnect between  
money supply growth and consumer price inflation has gone hand in  
hand with rising asset price inflation.  
William De Vijlder  
stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and  
immediately in private markets into cash to meet their liquidity needs for a 30 calendar  
day liquidity stress scenario.” (Source: BIS, The Liquidity Coverage Ratio and liquidity risk  
monitoring tools, January 2013).  
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.
Concretely speaking, during difficult economic times, banks may be reluctant to use their  
reserves as a basis for extending credit. As a consequence, the money multiplier declines.  
John C. Williams, “Monetary policy, money and inflation”, Presentation to the Western  
Economic Association, 2 July 2012.  
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