Talking-Head Economists, Please Take Note

Lots of talk about interest rates. The June quarter CPI showed that the CPI increased by 3.8 percent over the year to the June quarter versus 3.6 percent in the year to the March quarter. Oh dear, will the Reserve Bank respond by increasing interest rates yet again? Almost certainly not. But who knows what the Bank’s board will do next week? It has to wrestle with irrelevant Keynesian-style information on the state of so-called “demand” provided by the Bank’s expert economists. Focusing on the wrong economic variable means that decisions become toss-ups.

Let me talk about the variable that these days dare not speak its name. It is in fact the only variable that counts when it comes to inflation. To wit, the money supply. And, centrally, M1 money, the most dynamic transactional part of money, defined by the Reserve Bank “as currency plus bank current deposits from the non-bank private sector.” When individuals and businesses spend, M1 is the money they use overwhelmingly.

Between March 2020 and March 2022, M1 increased by 41 percent. No joking. A money supply splurge occasioned by the grotesque over-reaction to a mild to middling pandemic. We ain’t seen the likes before. Maybe Whitlam? Don’t know, haven’t checked.

Milton Freidman advocated a policy of bringing down monetary growth gradually and slowly to avoid precipitating a serious economic downturn.

Inflation was bound to happen and it did. What to do about it? Milton Freidman advocated a policy of bringing down monetary growth gradually and slowly to avoid precipitating a serious economic downturn. The money supply has to be brought back over time into a non-inflationary equilibrium with economic activity. Where are we in this process?

Since March 2022, M1 (seas. adj.) has very slightly declined from $1670.1 billion to $1669.9 billion in June 2024; call it no change. That is, over a period of 27 months, the stock of M1 money in circulation has remained static. Thus, the increase of 41 percent over the two-year Covid episode remains the increase over four and bit years. In comparison, GDP in current prices has increased by 33 percent between March (Qtr.) 2020 and March (Qtr.) 2024. Primitive figuring, okay, but it appears that we are probably quite close to having reestablished a stable alignment between the stock of money and economic activity. And, arguably, too quickly.

Perhaps the last rate rise from 4.1% to 4.35% in November last year was unnecessary and unwise. Perhaps, at a stretch, even the rise before that in June 2023 was unnecessary? Without those two rises the cash rate would now be at 3.85%. And small businesses and households with mortgages would not be struggling quite so much.

It must be remembered that inflation, once entrenched, is a Titanic. You can’t turn it around on a dime. What you do today might not have its effect for many, many months. Well over twelve months, according to Freidman. It is plain silly to be influenced by individual monthly and quarterly inflation numbers. Talking-head economists take note. There is too much noise and lags in the system to know what is happening through the lens of the latest inflation numbers.

A far better perspective is gained by looking at the annual growth rates of monetary aggregates. If they are coming down you know one thing – don’t further increase interest rates. If the growth rates in monetary aggregates are coming down too fast, it might be time to reduce interest rates. What is “too fast?” That, of course, is hard to say and in the end result will be a judgement call. Central banks will usually err on the side of caution. Having gone through the pain of increasing rates to curb inflation they tend to be reluctant bear the risk of easing them too soon. However, not being a central banker, it seems to me that the next direction of interest rates in Australia should be down. And, based on the latest money supply figures, tout de suite.