As part of the realignment of its monetary policy strategy, the Governing Council decided in the summer of 2021 that future monetary policy decisions would be based on two interlocking analyses, namely an “economic” and a “monetary and financial analysis”. The Governing Council thus remains nominally in the tradition of its “two-pillar strategy”; however, it is now completely refocusing and it seems that monetary developments are being relegated to a supporting role in the monetary policy decision-making process. In the “monetary policy statements” at the beginning of the ECB press conferences, the money supply is now hardly mentioned.
This irritates those who see the QE policy of recent years as a major reason for the current rise in inflation. In fact, evidence shows that the recent rise in inflation rates was preceded by a substantial acceleration in M3 growth (Figure 1). Inflation dynamics in the period from 2007 to 2015 appear to be following the previous M3 growth rate, which initially increased to 12% pa and then dropped to zero percent. Against this background, the downgrade of the monetary analysis appears to require some explanation and an assessment of what to make of it.
Initially, money played a “prominent role” in the Eurosystem’s monetary policy strategy, reflected in the announcement of a reference value (of 4.5% pa) for annual M3 growth. In doing so, the Eurosystem took account of the fact that “inflation is a monetary phenomenon in the medium to long term” and that price increases are generally “closely linked to growth rates of the money supply that exceed the medium-term real growth potential of the economy” (European Central Bank, 1999). Although temporary deviations from the reference value did not require an automatic monetary policy reaction (if they were based on special factors), M3 growth had the status of a monetary policy control variable that should be based on the reference value in the medium term. It is true that short-term shocks can impair the ability of the money supply to predict price developments because they have a direct effect on the price level. Such factors were assessed by the Governing Council of the ECB as part of the “economic analysis”, which, along with the development of the money supply, formed the “second pillar” of the Eurosystem’s analysis concept.
The decline in money supply began with the first review of monetary policy strategy in May 2003, when M3 growth became an indicator variable providing information about future price risks but no longer triggering a monetary policy response. In addition, the “economic analysis” for the first pillar was supplemented by a large number of indicators that served to identify short- and medium-term price risks. The “monetary analysis” became the second pillar and served to assess the medium and long-term inflation trend. M3 growth was supplemented with additional indicators describing the money creation process, in particular commercial bank lending. Consequently, the Governing Council ended the annual review of the reference value, which is no longer relevant today (Holm-Hadulla, 2021).
With the new announcement of the monetary policy strategy in summer 2021, the content of the second pillar was expanded to include a canon of financial indicators. Since then, the Governing Council of the ECB has consistently spoken of the “monetary and financial analysis”. The financial analysis contains indicators that allow assessing risks to financial market stability that affect the transmission of monetary policy through the banking sector. Monetary analysis is primarily concerned with the transmission mechanisms of monetary policy; the development of the money supply no longer plays a role in this.
Reasons for the strategy change – on the relevance of the quantity theory
The reason for the decline of the money supply as a forecasting tool is the loss of importance of the money supply-price mechanism. Already at the beginning of the monetary union, there was little information content of the money supply growth for the inflation rate in the short term; however, the monetary “basic dynamics” were still considered to be relevant for explaining the long-term price development. This, too, is now being questioned with reference to empirical studies that also point to a “weakened” empirical connection between the development of the money supply and the inflation rate in the long term (overview at Deutsche Bundesbank, 2023).
However, the results are not clear. Rather, Teles et al. (2016) in a cross-sectional analysis the validity of the “naive” quantity theory only for hyperinflationary countries, where the long-term inflation rate corresponds one-to-one to the money supply growth. For countries with low inflation rates (below 12% pa), however, the “modified” quantity theory continues to apply, as it was the basis for the monetary policy course of a “potential-oriented monetary policy” of the Bundesbank until 1999; thereafter, long-term velocity-adjusted money supply growth is inflationary when it exceeds production potential growth (for the eurozone, see also Mandler/Scharnagel, 2014).  In this respect, the quantity theory is “still alive”.
Risks of a short-term orientation
Nevertheless, monetary growth does not play a role in the Eurosystem’s quarterly inflation forecasts, which are of great importance for monetary policy decisions. The projections cover a forecast horizon of two to three years and are based on macroeconomic DSGE models that include a variety of indicators that do not include money (for methodology, see European Central Bank, 2016). The projections are shown in Table 1 from 2019 onwards, with a comparison with the actual inflation path shown in Figure 1 showing that the ECB did not anticipate the rise in inflation that started in autumn 2020, even though M3 had risen sharply beforehand.
It is difficult to assess whether the fit would have been better with money supply, although there is some research showing that including money increases the predictive power of DSGE models (Caraini, 2016). However, since mid-2020 at the latest, the M3 explosion could have prompted monetary policy to take very cautious note of the low inflation forecasts. In the “monetary policy statements” at the beginning of the press conferences, money supply growth up to June 2021 was mentioned, but not highlighted as a potential threat to price stability.
The current development of the inflation rate reveals a weakness in a policy of flexible inflation control, in which the Eurosystem is dependent on forecasts of future inflation developments. Such forecasts are based on DSGE economic models, which only allow the inflation rate to be estimated for a limited forecast period. With this short-term perspective, however, monetary policy runs the risk of underestimating the long-term influencing factors on the development of inflation and only reacting to an excessive expansion of the money supply when this is also reflected in the indicators that have been included in the short-term forecast model.
Don’t forget the amount of money!
The Eurosystem should therefore examine whether, in the future, it will (again) take greater account of the information resulting from monetary developments in its decision-making process and whether it will return to a policy that keeps M3 growth on a stable path in the medium and long term. It is surprising when a central bank (almost) completely disregards in its statements what the “regulars” (at least in Germany, but probably not only there) consider to be the main cause of inflation, namely the growth in the money supply.
Caraiani, P. (2016), The Role of Money in DSGE Models: A Forecasting Perspective, in: Journal of Macroeconomics, Vol. 47, S. 315-333.
Deutsche Bundesbank (2023), From the monetary pillar to monetary and financial analysis, in: Monthly Report, 75th year, March, Frankfurt/MS 15-43.
European Central Bank (1999), Monetary analysis for the euro area, in: Monthly Report, vol. 1, March, Frankfurt/MS 15-29.
European Central Bank (2003), Result of the ECB’s review of its monetary policy strategy, in: Monthly Report, Volume 5, pp. 87-102.
Europäische Zentralbank (2016), A Guide to the Eurosystem/ECB Staff Macroeconomic Projection Exercise, Frankfurt/M.
Holm-Hadulla, F., Musso, A., Rodriguez, D., Vlassopoulos, T. (2021), Evolution of the ECB`s Analytical Framework, European Central Bank, Occasional Paper, no. 277.
Mandler/Scharnagel (2014), Money Growth and Consumer Price Inflation in the Euro Area: A Wavelet Analysis, Deutsche Bundesbank, Discussion Paper, No 33/2014, Frankfurt/M.
Teles, P., Uhlig, H., Valle e Azevedo (2016), Is Quantity Theory Still Alive?, in: Economic Journal, Vol. 126, S. 442-464.
) However, the fit between the adjusted money supply growth and inflation becomes poor for low-inflation countries if one restricts oneself to periods with inflation targeting, because then the inflation rates between the countries in the sample hardly differ.