Quite some developments have happened this year which had been considered as unthinkable not long ago. We have witnessed an unprecedented slump in economic activity, but at the same time equally unprecedented rescue packages by monetary and fiscal policy. As many of these measures were assembled under great pressure, one might ask as to whether the hastily administered measures might not develop some undesirable side effects.
One indicator that has shown a remarkable development since the onset of the crisis is the growth of money supply. In the United States, the Eurozone, the UK, China, virtually everywhere monetary aggregates are rising sharply. For monetarists, such a development naturally sets alarm bells ringing. Is this a harbinger of an equally sharp rise in inflation? Might there be a connection between the strong growth of the money supply and rising inflation expectations, as they are priced in inflation-indexed bonds?
As our "Chart of the Week" demonstrates, a correlation between the growth of money supply M3 and inflation, which theoretical models claim to exist, can also be observed in reality. For the Eurozone, current money-supply growth would suggest a (core) inflation rate of around 1.5%. However, the statistical correlation is anything but perfect.
There are several drivers for the current increase in the money supply. For one, the public sector has expanded credit enormously to compensate for the expected tax shortfall and increased spending, thus holding large amounts of liquidity at the moment. The corporate sector, too, has upped its liquidity position by increasing debt, not least thanks to generous state-guaranteed loans schemes. In addition, corporate-bond issuance has also risen to record levels, which in the context of central-bank purchases led to higher money supply.
On the other hand, we are still coping with a highly fragile economic situation. Millions of employees remain on short-time work schemes. In view of the precarious situation in labor markets worldwide, we would not expect much upside potential for wages. Weak demand and a drastic under-utilization of capacities also do not support the case for a rapid rise in inflation rates. Other factors, like a temporary reduction in the value-added tax in Germany, have pushed inflation rates lower, in some cases even into negative territory.
In this respect, we would not see any major inflationary risks for now. In the longer term, though, we believe there are some factors that could well lead to higher inflation rates in a few years' time. This does, however, go well beyond the usual lead of money-supply growth.
Sources: European Central Bank, Eurostat, DWS Investment GmbH as of 9/2/20