Looks like Milton Friedman was right about global inflation

Well, guess what happens when China starts experiencing its own structural problems and then shuts down its economy due to COVID-19 – not once but twice – just as the West increases nominal demand through money in the hands of households?

Today, it’s not just domestic money that matters. In a globalized world, what other countries do is also important. Global money facilitates nominal demand for supplies coming from many parts of the new world. Prices are affected for everyone.

Looking in the wrong place

If we add up the US, European and Japanese money supply in US dollars and compare it with US inflation (as an indicator of world inflationary pressure), an interesting picture emerges.

Global money has been the leading indicator of plausible inflation since the financial crisis.

Central banks which all failed to predict the outbreak of inflation certainly did not see the money supply.

Recently a new inflection point has appeared in the downward direction. The monetary variable has fallen sharply, stretching the “elastic band” with inflation to its peak.

Something will happen as a result, and it may be unpleasant.

There are two reasons for the sharp cash reversal (none of which has to do with the central bank’s quantitative easing policy).

The first reason is that COVID-19 payments, which for the first time since the global crisis pushed a lot of money into household bank accounts (rather than bank deposits at central banks), fell back to zero. Then COVID-19 money dropped out as a source of new nominal demand this year.

The second reason is that the Fed, realizing its mistakes, started tightening faster than any other central bank and the dollar has soared. This depressed purchasing power in Europe and Japan. The dotted line on the chart shows what the path of global money in terms of the US dollar would look like if the exchange rate had stayed at that level in June last year.

Instead of minus 3.8 percent, the number will be 5 percent to 6 percent. That 9 percent to 10 percent difference reflects the cost of living pressure transmitted outside the US by the dollar. Their international purchasing power in global supply chains is falling, including for politically sensitive food and fuel costs. This will weaken demand outside the US and wages don’t keep up.

Central banks which all failed to predict the outbreak of inflation certainly did not see the money supply.

The ECB and the Bank of Japan need to continue. They can do something to influence their purchasing power by coordinating their monetary policy more closely with the US. But they feel constrained.

Japan’s easy policy was the long-standing Mercantilist belief in the exchange rate to stimulate exports. The ECB case is more complex. They are trapped in a misunderstood currency union. They don’t want to blow up Italy and bring Europe back into the shadow currency crisis of 2009-10 which manifested itself as a sovereign debt crisis. Higher rates might do that.

Cracks visible

Another element in the inflation story is the “China shock” path. The growth in supply measures in the chart has been declining since 2014 due to China’s own structural problems. This has been followed up by two closures due to the mismanaged Covid pandemic.

Believing in a destiny unhindered by democratic processes and market discipline, China has been building debt at an unprecedented pace. At the end of last year, its debt rose to 287 percent of GDP, surpassing the US (a much richer country) by 281 percent.

Amazing really. Excess investment is present in many Chinese industries.

Perhaps the most interesting observation is that major cracks are emerging in President Xi Jinping’s signature project, the Belt and Road Initiative. New big construction projects dry up.

This year only East Asia (where China’s political power is strongest) has received reasonable inflows, including in Papua New Guinea, the Philippines, Laos, Indonesia and Thailand, all very close to home.

Direct investment in foreign companies has fallen more sharply and problematic transactions have increased. Many investments have been misjudged (including in Australia). The absence of market discipline will do that.

While it is difficult to imagine China’s credit-driven supply response as in 2008-09, there will be a strong but temporary bounce as the COVID-19 shutdown is lifted. More moderate growth will then follow.

The supply side will improve, although not as in the 2007-14 disinflation period.

Summing it all up, the trend in the chart suggests inflation will decline in 2023. But the sharpness of the reversal also suggests that the recession is now a serious risk.

We are in uncharted waters and care needs to be taken to avoid further policy mistakes in Western central bank policy. New problems need to be addressed. Coordination of monetary and currency policies should be one of them. For the inflation forecasting process, it is necessary to start again. Milton Friedman’s key insights into global change may help in that rethink.

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