Dr John Greenwood, our Honorary Fellow and well-known monetary economist, recently shared with us his perspective on the current inflation. He argued that money supply is the key and persistent driver of inflation, instead of interest rates that some central banks are currently focusing on. 

The insightful session invoked many questions from the audience, and Dr Greenwood generously shared his views on them, even questions which were not addressed during the session –  regarding the control of inflation, the US economy and investment under the inflationary environment.

Check out Dr Greenwood’s answers below. If you have missed the webinar, click here to watch the session.

Control of inflation

Q: Oil prices and commodity prices are down now, would it help reduce inflation?

A: Only in a superficial sense. If oil and other energy prices decline, the result will be a short-term impact on the official or measured price indices, but reducing the oil price does nothing to reduce the excess money supply in the economy – which is the true source of the inflation. It is better to control money growth and allow the free market to sort out the prices in individual sectors.

Q: It appears that the excess money released by central banks during 2020-21 is unlikely to be lowered to the prior level, so does it mean this will push up the overall price persistently?

A: Yes. The reason I showed the picture “The Great Wave off Kanagawa” by the Japanese woodblock artist Katsushika Hokusai during my talk was to encourage you to think of the excess money growth as being like a sudden giant wave – a tsunami. Just as the excess water will spread over the land for a long distance, the excess M2 will spread across the economy affecting real growth and inflation for at least 2-3 years. So, yes, I expect inflation will remain elevated through 2023 and into 2024.

Q: Is there an optimal ratio between money supply and GDP?

A: No, it varies by country and according to payment habits, the structure of the banking system, etc. But in every country that I have looked at there is a fairly stable but steadily rising ratio of money to nominal GDP. This is a far more stable relationship to rely on than concepts like the fiscal multiplier from government spending.

US Economy

Q: Where are we now in the business cycle? Referring to your asset allocation chart vs business cycle, are we in phase 5* from cash to bond?

A: The US economy is probably somewhere between Phase 4 (economy approaching the peak of the business cycle) and Phase 5 (economy starting to turn down). However, we can never be too precise about the phases. Currently it seems as though the nominal part of the US economy – prices, spending power in current dollars, wages etc – are still booming (Phase 4) because of excess money over the past two years. On the other hand, the real economy – real GDP, real retail sales, industrial production etc – is slowing down fast (Phase 5) because of the deceleration of money during the past 6-9 months.

Q: When do you think the interest rate in the US will peak?

A: Probably not until 2023, but interest rates are less important than money growth.

Q: Is quantitative tightening (QT) a better tool than raising the interest rate to reduce inflation in the US? What the Fed should do to eliminate the excess money? If they do, what will be the effect on the financial markets?

A: QT reduces the size of the central bank’s balance sheet and the money supply, provided that commercial banks do not create loans which offset the QT policy.

The best policy would be to keep M2 growth at around 5.5% p.a. Of course, it is hard to envisage a favourable effect on financial markets because lower money growth will lower asset values, raise interest rates etc.

As long as the Fed does not focus on money supply, we cannot be confident that the Fed will manage the slowdown of money growth efficiently. They could make one of two mistakes – either reducing the growth of M2 too much, or not enough. It is difficult to say what the outcome will be, but at the moment they are allowing it to decline too much and too fast.

Capital Market

Q: What is your view on equities under inflation and the rise of interest rates?

A: Very negative. So far, we have mainly seen PE ratios decline due to rising interest rates. The next phase will be slowing or declining earnings (EPS or profits) as the US economy goes into recession.

Q: What would be good investments in terms of asset allocation under such an inflationary environment?

A: My talk was not intended to provide investment advice. However, in my view you need either inflation-protected assets (such as Treasury inflation-protected securities) or USD cash, but it will depend on your risk tolerance.