According to Statistics Canada’s latest consumer price index report, in February the annual inflation rate fell to 2.8 per cent, raising the prospect of interest rate cuts by the Bank of Canada sometime this year. “Inflation is caused by too many dollars chasing too few goods” used to be the traditional diagnosis of the cause of inflation, prompting central banks to fight it by slowing the growth of the money supply. This approach is based on what is known as the “monetarist” theory of inflation, which suggests that supply shocks such as those associated with the COVID pandemic do not cause inflation but only a temporary increase in the price level, which is reversed once the cause of the shock ends—unless the money supply has increased.

In recent decades, central banks have fought inflation using interest rates instead of monetary growth. This switch followed the postwar success of Keynesian theory, which blames inflation on excess aggregate demand, which higher interest rates are supposed to curtail.

Targeting interest rates can work if central banks simultaneously pay attention to money growth, but too often they’ve failed to do so. Equally, targeting the money supply can create inflation-fighting interest rates. However, interest rate targeting in practise has a serious shortcoming. Aggregate spending is influenced by real interest rates while central banks can set only nominal rates and real rates are beyond their control because they cannot change inflation by any direct policy.

This important problem arises because, for example, a nominal interest rate of 6 per cent turns into a real rate of minus 2 per cent if the expected inflation is 8 per cent. At that rate, investors can borrow $1 million at 6 per cent, use the money to buy real estate, sell it a year later after it has appreciated at the expected 8 per cent, repay the $1 million and take home a capital gain of $20,000. In other words, the high expected inflation rate incentivizes consumers and businesses to borrow more, which results in faster money growth and risks even higher inflation.

The expected rate of inflation exists only in peoples’ minds and is determined by many factors. The Bank of Canada collects as much information as it can, drawing on the results of public surveys, the information contained in the prices of so-called Real Return Yields, and sophisticated economic models produced by the Bank’s economists. But these efforts do not result in reliable information, as evidenced by the uncertain and speculative nature of economic forecasts found in its economic updates.

The problems associated with not knowing the real rate of interest have persuaded some economists, called “monetarists,” to urge central banks to target the money supply including famed economist Milton Friedman whose monumental study of the history of U.S. money supply and inflation inspired many including David Laidler, emeritus professor at the University of Western Ontario, and Britain’s John Greenwood who maintains a large database he used to create the accompanying graph.

This graph shows Canada’s annual rate of inflation (measured on the left axis) and the annual rate of growth of the money supply (M3) (measured on the right axis) for the years 2014 to 2024 using data published by the Bank of Canada and Statistics Canada, which require little manipulation. The annual percentage change in the money supply is averaged over 12-months, as is done widely to smooth data that fluctuate much over short periods; and the resultant time series is shifted forward 18 months, to achieve the best fit between changes in money growth and changes in inflation in the monetarist tradition, which has found the lag to have been variable historically between 12 and 18 months. (Thus, the peak smoothed money supply growth rate of more than 13 per cent occurred in February/March 2021, but is shown as occurring in August/September 2022, some 18 months later and close to the peak of inflation in June 2022.)

The correlation between the quantity of money and inflation shown is not perfect but strong enough to justify the conclusion that Canada would have avoided the inflation starting in early 2021 had the Bank not increased the money supply so dramatically during the first year of the pandemic.

In 1994, John Crow, then-governor of the Bank of Canada, presented to a parliamentary finance committee a report on the economic outlook. One of the authors of this op-ed (Grubel) was at this meeting. In response to his question, Crow said that the Bank’s econometric forecasting model did not include data on the money supply but that he always looked over his shoulders to ensure it does not get out of line. If his successors had followed his practise, perhaps Canada’s present inflation would have been avoided.

But then it would not be possible to test the usefulness of the model, which draws on money supply growth data over the last 18 months to predict that inflation should fall to 2 per cent near year-end 2024 or early 2025.

If the prediction is realized, however, Canadians should not expect the lower inflation rate to result in lower costs of living. That would happen only if the Bank made the money growth rate negative, something history suggests is unlikely because it usually resulted in recessions. How much better it would have been if the inflation genie had never been allowed out of the lamp.