Money Growth, Inflation and the Business Cycle

Lars Risbjerg, Economics

INTRODUCTION AND SUMMARY

The money stock is not normally at the forefront of most central banks' monetary-policy deliberations, despite its prominent role in large parts of the theoretical economic literature. One explanation is that the correlation between money growth and inflation has proved to be unstable, particularly in the short term. In the long term, on the other hand, money and inflation are often closely related across monetary-policy and exchange-rate regimes. So in the long term inflation is often regarded as a monetary phenomenon, even though a strong long-term correlation between money growth and inflation does not as such shed light on cause and effect in the link between money growth and inflation.

Money growth has recently been relatively strong both in Denmark and abroad. Denmark’s money growth is slightly higher than the current economic conditions and interest rates would normally warrant. This may in part be attributed to the increase in bank deposits, and thus in the money stock, in connection with the higher remortgaging activity and realisation of capital gains in continuation of the large increases in housing prices.

In recent years money as an indicator of the business cycle and trends in equity and housing prices has received increased attention in the international debate. The money stock and housing prices are procyclical and are affected in the same direction by the course of long-term interest rates. Money tends to be a leading cyclical indicator since money demand reacts more quickly than economic activity to interest-rate changes. This also applies to the development in housing prices and remortgaging activity, which can amplify money demand – as described above.

This article first discusses whether money growth in Denmark is exceptionally high, followed by a review of the empirical correlation between money growth and inflation in the short and long term. In conclusion, the correlation between money, credit and housing prices over the business cycle is examined.

DEVELOPMENT IN MONETARY AGGREGATES

The monetary aggregates applied in Denmark are described in Box 1, and the development in various monetary aggregates is shown in Chart 1.

MONETARY AGGREGATES	Box 1
M1 is defined as the private non-bank sector's holdings of currency in circulation and overnight bank deposits. M2 is typically defined as M1 plus short-term time deposits. M3 is normally defined as M2 plus certain other deposits and holdings of short-term debt instruments. The exact definition of monetary aggregates in a Danish context appears from Danmarks Nationalbank's statistical publications. M3 amounted to kr. 798 billion at end-2005. The Chart below shows the breakdown of M3.
BREAKDOWN OF M3 END-2005
In recent years, the development in M3 has been affected by issue of short-term bonds to finance adjustable-rate mortgage-credit loans. Underlying bonds with an original maturity of up to 2 years are included in M3, whereas bonds with an original maturity of more than 2 years are not included. This may entail large fluctuations in relation to M2 around the turn of the year, illustrating that the information content of M3 is often modest as far as Denmark is concerned.

The relatively high money growth is in part attributable to technical aspects of the mortgage loans offered by banks. When granting a loan against home equity as collateral, a bank often at the same time establishes a deposit account containing the nominal loan proceeds. This entails a simultaneous increase in deposits of the same magnitude, i.e. the money stock expands. The increase in deposits is reduced as the loan proceeds are withdrawn. Excluding the effect of the banks’ mortgage loans on deposits is estimated to reduce the annual money growth by a couple of percentage points.

Money demand in Denmark has been examined a number of times in recent years.^[1] If the monetary aggregates have taken an unusual course recently compared to the estimated money demand, this may indicate that the previous results no longer apply. Money demand is generally explained by the volume of transactions, expressed in terms of nominal domestic demand, and the remuneration of money compared to other claims, calculated as the difference between the rate of interest for deposits with banks and the 10-year government bond yield. The higher the transaction need and the higher the remuneration of money compared to other placements, the greater the money demand.

In general, the developments in the actual money stock and in the estimated long-term money demand are in line with each other.^[2] However, since 2003 the money stock has increased slightly more than warranted by the estimated long-term relation, cf. Chart 2. A similar temporary deviation was observed during the upswing in the 1990s, cf. the section on the business cycle, money, credit and housing prices below.

MONEY AND INFLATION

Inflation can be regarded as a monetary phenomenon in the long term. The long-term correlation between money growth and inflation is often described using the quantity equation, cf. Box 2. However, the correlation between money growth and inflation has proved to be unstable. Furthermore, monetary development is to a high degree beyond the control of the central bank. These factors have contributed to the diminishing focus on the money stock, although money growth, together with growth in lending, plays an important role in the ECB's monetary-policy strategy.^[3] In a small open economy like Denmark, with a fixed exchange rate and liberalised capital flows, the money stock is solely determined by the demand for money. In the larger countries, money is only rarely directly included in the macroeconomic models applied by e.g. central banks.^[4]

In Denmark, a negative correlation between inflation and money growth in the short term has often been observed, cf. the left-hand side of Chart 3. This applied particularly in the period 1983-85 when money demand rose strongly, whereas inflation declined. Part of the explanation is that the transition to a fixed-exchange-rate policy in 1982 was gradually gaining credibility, thus reducing devaluation and inflation expectations in Denmark. This resulted in a considerable decrease in long-term interest rates and a narrowing of the spread between long-term and short-term interest rates. This resulted in simultaneously growing interest in deposits and declining inflation.^[5]

One way of analysing the development in money and inflation over various horizons is to break down the development in money and in prices into different cyclical components, i.e. the short term of 1.5-8 years, the medium term of 8-20 years, and the long term of 20-40 years, cf. Box 3. To a high degree the very short-term waves for cycles lasting less than 1.5 years represent noise. The part of inflation and money growth that moves in short-term waves, i.e. high-frequency fluctuations, often displays negative correlation. This also applies to business cycles lasting 1.5 to 8 years, cf. the right-hand side of Chart 3.

For a longer horizon, money growth and inflation are more closely linked. However, divergent developments are often observed in the frequency area equivalent to 8-20-year cycles, cf. the left-hand side of Chart 4. For the very low frequencies, i.e. 20-40-year cycles, the correlation between money growth and inflation is high, cf. the right-hand side of Chart 4. Money does not seem to lead inflation in the long term, however.

Viewed over a very long period across various monetary-policy regimes, there is also close long-term correlation between money growth and inflation, cf. Chart 5.^[6] Similar results for the connection between money growth and inflation in the short and long term also apply for other countries.^[7] The long-term correlation is difficult to apply in practice, however. A technical problem is that determination of the trend in the last observations in filtered data is uncertain.

The above analysis does not as such provide a basis for conclusions as to the direction of the causality between money growth and inflation. In a Danish context, money growth is determined by demand and, like inflation, influenced by economic activity and interest-rate levels, among other factors. The most obvious interpretation of the long-term correlation between money growth and inflation is therefore that it reflects the influence of a common set of factors.

THE BUSINESS CYCLE, MONEY, CREDIT AND HOUSING PRICES

Financial variables such as lending by banks and mortgage-credit institutes to households and non-financial corporations can be used as early indicators of economic development since lending data for a given quarter is published before GDP data. Lending by banks is the largest counterpart of money in the banks' balance sheets and in general, monetary and credit growth follow the same course, i.e. that of GDP, cf. Chart 6. However, the developments in money and credit vary during a business cycle. An impression of the cyclical relation between money and credit can be gained by calculating the correlation between the cyclical component of real GDP on the one hand and the cyclical component of money and credit at various dates on the other.^[8] More specifically, the correlation between real GDP and values of lending and money in the 8 preceding quarters, the current quarter and 8 subsequent quarters is calculated.

Chart 7 shows the correlation between GDP on the one hand and money and credit on the other. The correlation between GDP and values of money and credit in the preceding quarters is shown in the left-hand side of the Chart, while the correlation between GDP and values of credit and money in the subsequent quarters is shown in the right-hand side.

High cyclical values of money tend to precede high cyclical GDP values. The correlation then declines to a negative level. In overall terms, credit shows the opposite correlation pattern. To begin with, the correlation between the cyclical component of GDP and preceding values of the cyclical component of credit is negative. Hereafter it increases. The USA and the euro area show similar cyclical correlation patterns for money and credit, cf. Chart 8.^[9]

In an upswing, lending to households will typically begin to increase before lending to non-financial corporations, cf. Chart 7. Lending to non-financial corporations will typically begin to rise at a rather late stage of the upswing since the necessary expansion of the capital stock that is crucial to continued economic growth can at first be financed from own funds generated from higher earnings. Increased lending is thus only required after this point.^[10]

The significance of interest-rate developments
There is positive correlation between money growth and growth in lending on the one hand and housing price increases on the other. The explanation for the positive correlation between the development in money, credit and housing prices is that the variables are typically procyclical and tend to move in the same direction on a shift in long-term interest rates.

Money stock and housing prices tend to react early in an upswing. Part of the explanation can be that housing prices and money typically react more quickly than domestic demand to movements in long-term interest rates. The upswings at the beginning of the 1980s and in the 1990s were thus both preceded by a significant drop in the long-term interest-rate level. The upswing that began in 2003 also coincided with falling interest rates, from an already low level. Chart 9 illustrates the generally close cyclical correlation between housing prices and long-term interest rates. Money demand was stimulated in connection with the sharp decline in long-term interest rates at the beginning of the upswings in both the 1980s and the 1990s since the spread between long-term and short-term interest rates also narrowed.

The significance of housing prices and mortgage financing
The characteristics of money as a leading indicator for GDP can also be related to the development in asset prices. In general, changes in asset prices may influence money since they may give rise to reallocation between assets or between consumption and savings.^[11] This may entail placing deposits with banks at varying maturities. In particular, rising housing prices may lead to realisation of capital gains on housing either in the form of supplementary borrowing in connection with conversion of mortgage-credit loans or in relation to purchase and sale of homes.^[12] The realised capital gains can be (temporarily) placed as bank deposits, causing the money stock to expand, before they are used for consumption or residential investments, or are placed in other financial assets. Chart 9 illustrates the close cyclical correlation between housing prices, money and mortgage-credit loans to households.

The strong growth in housing prices and the high volume of conversions, which was supported by the introduction of new home-financing products,^[13] may explain part of the recent discrepancy between actual and estimated money demand. The correlation between M1 and early redemptions is shown in Chart 10.

Similarly, money demand in the early 1990s, when actual money demand was also somewhat higher than estimated money demand, may have been supported by the liberalisation of mortgage-credit legislation in the early 1990s, which enhanced the access to supplementary borrowing and reintroduced 30-year annuity loans. The subsequently falling interest rates triggered substantial conversion activity.^[14]

Money and credit are some of the indicators used by the ECB to gain information on potential financial imbalances. Such information is relevant to the ECB's monetary policy, as financial imbalances may have a destabilising effect on economic activity and thus on price developments. In an international context too there is now more focus on the role of money and credit as indicators of the course of equity and housing prices and the derived effects on economic activity. In particular it is considered whether money and credit can be applied as indicators of an imminent peak in housing and equity markets, that may be succeeded by a recession.^[15] Other surveys point out that growth in housing prices and real investments are good indicators of an upswing which may potentially be followed by a recession.^[16]