An article in November presented a “monetarist” forecast of a rise in UK annual CPI inflation to 3.2% in Q4 2021, far above the Bank of England’s central projection of 2.1% (reduced to 1.9% in February). News since then has been consistent with the assumptions underlying the forecast, which is maintained.

January inflation of 0.7% was slightly above the forecast for the month made in November.

Economists share the Bank’s relaxed view of prospects. The median Q4 projection in the Treasury’s latest survey of independent forecasters is 2.0%. Only one contributor expects an outturn above 3%*.

The assumptions underlying the forecast are set out below but the key differences from the Bank / consensus are 1) a larger rise in global commodity prices and associated stronger paths for energy / food inflation, 2) a more pessimistic assessment of current core trends, and 3) an expected increase in core inflation in response to last year’s broad money surge.

The commodity price view is on track, with the Brent oil price up by 40% since November and Ofgem hiking the energy price cap by 9% from April – above a 5% assumption in the November forecast. The FAO world food price index, meanwhile, rose by 7% between November and January, pushing annual growth up to 11%.

The preferred broad money measure here (i.e. non-financial M4, comprising money holdings of households and private non-financial corporations) continued to rise strongly in November / December, with annual growth now at a 31-year high of 14.2% – see chart 1.

Chart 1 

Previous research documented a leading relationship between broad money growth and core CPI / RPI inflation in post-WW2 data, with an average lead time at turning points of 26-27 months. The lead, however, varied widely and was affected particularly by exchange rate developments. A fall in money growth in the late 1990s, for example, was swiftly reflected in core inflation because of prior sterling strength. The lead was much longer after the GFC, when a large fall in the currency placed extended upward pressure on import prices.

Sterling’s effective rate has firmed 3% since November but is little changed from a year ago. A reasonable assumption, therefore, is that the lead time from money growth to core inflation will conform to historical average experience, implying a rising core rate through end-2022, at least.

An assessment of current core trends is complicated by the temporary VAT cut for hospitality and tourism. The assumption here is that one-third of this cut was reflected in prices, in which case core inflation (i.e. ex. energy, food, alcohol and tobacco) of 1.4% in January is understated by 0.7 percentage points (pp). The Bank of England and consensus assume that pass-through was much lower.

The forecast, accordingly, assumes a 0.6 pp boost to published core inflation when VAT for these industries is normalised – currently scheduled for April but possibly to be delayed**. The Bank / consensus view, by contrast, implies little impact. The VAT reversion is likely to coincide with excess demand for these services as the economy reopens, suggesting scope for providers to hike prices to protect current margins – the assumption of one-third pass-through could be too conservative.

Chart 2 shows projections for headline inflation, the published core measure and the policy-adjusted core series calculated here. These incorporate the same assumptions as in November, except for a small change in the Ofgem energy price cap.

• A rise in inflation for food, alcohol and tobacco to 2.0% in December 2021 (2010-19 average = 2.5%, January = 0.4%).
• A return of vehicle fuel prices to their pre-covid level (unleaded petrol = £1.28 per litre).
• A further 3% increase in the Ofgem energy price cap in October.
• Monthly growth in core prices excluding tax effects of 2.25% at an annualised rate.

Chart 2

Note that the headline and published core rates will be artificially high in Q4 because of a reversal of the VAT effect. This distortion will end in April 2022, assuming that VAT is normalised in April 2021. Adjusted core inflation, however, is likely to have risen further by then, suggesting limited decline in headline / published core rates.

What could derail this forecast? A significant further rise in the exchange rate could push back an inflation pick-up but bullish positioning in sterling may already be extreme, judging from Consensus Inc. sentiment and US CFTC futures data – risks may now be skewed to the downside.

Inflation prospects beyond 2021-22 will depend on broad money developments this year. Monetary deficit financing has given as large a boost to broad money growth in the UK as in the US – chart 3. With little appetite for fiscal restraint***, and the Bank of England restored to its historical role of government financing arm, it is likely to remain a significant driver this year, suggesting low probability of money growth returning to its post-GFC average (i.e. over 2010-19) of 4.2%.

Chart 3

*Economic Perspectives (Peter Warburton).
**The impact is asymmetric because of changes in weights.
***The claim that low bond yields “make it a good time for governments to borrow” is misleading, because deficits are being financed by monetary expansion (and an implicit future inflation tax) rather than borrowing from savers: low yields would be unlikely to survive a switch to non-monetary financing.

G7 headline consumer price inflation will spike in H1 2021, possibly reaching 3-4%, which would mark a 13-year high. Central banks will portray the rise as a temporary blip but the “monetarist” view is that higher inflation is related to the 2020 broad money surge and will be sustained into 2022. A key issue is whether G7 broad money growth will return to its low post-Global Financial Crisis (GFC) average in 2021. Monetary financing of enlarged fiscal deficits was the key driver of the 2020 surge and is likely to remain a significant contributor in 2021, suggesting that broad money will grow by 5-10% over the course of the year.

G7 core CPI inflation, i.e. excluding food / energy and adjusting for policy effects such as VAT changes in Germany / the UK and Japan’s travel subsidy programme, is estimated to have been stable at 1.3% in January – see chart 1. Mainstream forecasters had expected a significant fall in response to last year’s economic weakness but the latest reading is exactly in line with the post-GFC average (i.e. over 2010-19).

Chart 1

Headline inflation remained below core in January but the headline / core gap will spike during H1, reflecting recent commodity price strength and base effects. The relationship in chart 2 suggests that the gap will reach 2 percentage points or more, in which case stable core inflation of 1.3% would imply a headline rate peak of 3-4%.

Chart 2

Central banks and the consensus are expecting a pick-up, though probably not on this scale. The official response will be insouciance – an inflation comeback, it will be argued, would be welcome but the rise is temporary / technical, with output gapology signalling future weakness. Headline inflation is indeed likely to retreat during H2 but the “monetarist” view is that it will continue to exceed forecasts into 2022, reflecting last year’s broad money surge and an average two-year lead from money to prices. Commodity prices may strengthen further later in 2021, with core inflation lifting into 2022.

Chart 3

Medium-term inflation prospects, on this view, hinge critically on whether G7 broad money growth will return to around its low post-GFC average of 3.7% during 2021. Annual growth, estimated at 16.4% in January, will fall sharply from March as negative base effects kick in but the central case here is that it will end the year at 5-10%, consistent with a lasting inflation upshift.

The central case recognises that monetary financing of fiscal deficits was the key driver of the broad money surge and – with deficits remaining large – is likely to make another sizeable contribution this year. Bank lending to the private sector is projected to grow weakly but not to contract, as it did after the GFC as banks sought to pare their balance sheets to boost capital ratios.

Chart 4 shows the main credit counterparts of US broad money* growth. Monetary deficit financing – defined as net lending to the federal government by the Fed and private monetary institutions – accounted for an estimated 13.2 percentage points (pp) of annual broad money growth of 21.2% in January. The Fed’s purchases of agency MBS added a further 3.5 pp, with growth of commercial banks’ loans and leases contributing only 1.5 pp.

Chart 4

The rise in monetary financing mirrored the blow-out of the federal deficit, which reached 16.0% of GDP in 2020 – chart 5. Non-monetary financing as a share of GDP – the gap between the black and blue lines – was slightly larger in 2020 than in 2019, though smaller than in 2018.

Chart 5

The CBO’s revised baseline budget forecasts released last week suggested a fall in the federal deficit to below 9% of GDP in 2021 on unchanged policies. President Biden’s stimulus package could, on a conservative estimate, maintain it at about 13% of GDP. Assuming that monetary financing covers the same proportion as in 2020, the implied contribution to broad money growth in the 12 months to December 2021 would be about 9 pp.

Will a contraction in commercial bank lending pull down broad money growth, as it did after the GFC recession? The latest Fed senior loan officer survey reported a reduction in credit tightening along with a modest recovery in demand – chart 6. Bank lending may make little contribution to money growth in 2021 but is unlikely to be a major drag.

Chart 6

Fed purchases of agency MBS are running at $40 bn per month, suggesting a 2 pp contribution to broad money growth over a year. Other credit counterparts could conceivably have a negative impact (e.g. banks’ net external lending if capital were to flow out of the US in scale) but a reasonable base case is money growth of at least 5% during 2021 and probably significantly higher.

A similar argument applies in other G7 economies. Monetary deficit financing accounts for the bulk of recent UK broad money growth and has also been a key influence in the Eurozone. Fiscal deficits may show an earlier decline than in the US but bank lending to the private sector could make a larger contribution, reflecting official subsidy and guarantee schemes.

*M2 plus large time deposits at commercial banks plus institutional money funds.