Bank of England should be cautious reducing interest rates when the money supply is expanding rapidly
Congdon bases his conclusions on analyses of three episodes in the UK, including the two notorious boom-bust cycles of the early 1970s and late 1980s, as well as the Great Depression in the USA between 1929 and 1993, and the prolonged malaise in the Japanese economy since the early 1990s. The study shows that the level of monetary growth is a key influence on asset price movements. These, in turn, have a powerful effect on incomes and expenditure and inflation.
It is currently fashionable to downplay the relationship between money and inflation and focus on the role that interest rates play in monetary policy. Congdon shows that this is misguided. Congdon also believes that it is misguided to focus on narrow money when setting monetary policy. “It is difficult to believe that M0 (narrow money) could ever have been central to the asset price inflation that was such a notorious element in the boom-bust cycles.”
Crucial to the relationship between money and inflation is the behaviour of financial institutions such as insurance companies and banks. An expansion of their holdings of broad money leads them to increase their purchases of securities thus creating the asset price booms. For example, in 1987 insurance companies and pension funds’ holdings of broad money rose by nearly 60%. there was then a surge in asset prices and in inflation. Then, in the early 1990s, money holdings of financial institutions fell and the asset price and general economic bust soon followed.
These patterns are also seen in other asset price “boom and busts” and inflations and deflations, such as in Japan in recent decades and in the Great Depression in the US.
Given the current level of monetary growth in the UK, it is important that these lessons are understood by central bankers, including the Monetary Policy Committee of the Bank of England. If the signals in broad money growth are ignored, interest rates could be lowered and monetary policy loosened too early and too far.
Read the full study here.