A timely new book from the Institute of Economic Affairs, a free market think tank, explains why most economists and central bankers were caught off guard by the cost of living crisis in 2022. This comes as the Bank of England could cut interest rates tomorrow (20 June 2024) for the first time since March 2020.

During the Covid-19 pandemic, it was widely believed that inflation would decrease and prices might even decline. Professor Tim Congdon, Chairman of the Institute of International Monetary Research, was one of the few economists who foresaw the inflationary threat as early as June 2020.

In his new book, The Quantity Theory of Money: A New Restatement, Congdon argues that many economists misunderstood the causes of inflation by neglecting a crucial factor: the quantity of money circulating in the economy.

Congdon specifically criticises the Bank of England’s ‘New Keynesian Model’, which uses interest rates – and only interest rates – in the monetary part of the forecasting exercises in which they predict inflation. This model caused Monetary Policy Committee members to mistakenly warn of deflation throughout 2020 and fret about insufficient stimulus.

The Committee overlooked the inflation dangers inherent in the rapid expansion in the money supply, arising largely from the Bank of England’s large asset purchases (or Quantitative Easing [QE]). An early warning sign that surplus cash artificially boosted asset prices was that the FTSE 100 hovering near record levels by January 2021, despite the pandemic's devastating impact on the economy and company profits.

According to Congdon, central bankers aiming to control inflation should analyse 'Broad Money,' a measure of money balances that includes virtually all bank deposits. The principle that the money supply influences inflation is well-established and is commonly known as the Quantity Theory of Money.

“The main propositions of the quantity theory are fundamental to any analysis of the relationship between money and inflation in the 2020s," writes Congdon. “Its central message accords with the laws of supply and demand. If too much money is created, its value will fall, whereas – if an economy becomes short of money – its value will rise.”

Congdon stresses the importance of maintaining monetary equilibrium for price stability, arguing that broad money growth should be aligned with the growth of nominal GDP to prevent inflation or deflation.

This book underscores the urgency for policymakers to reassess monetary policy to avoid repeating past errors.

Flawed models – and bad monetary policy decisions based on those models – were made by central bankers and other policymakers in 2020 and 2021, as they responded to the Covd-19 medical emergency. This led to a serious and unnecessary flare-up in inflation. I was almost alone in late March 2020 in forecasting that central banks' reaction to Covid-19 would lead to an explosion in money growth and a consequent big jump in inflation.

Economists failed to identify the inflation risk because of their obsession with interest-rate-only macroeconomics (such as three-equation "New Keynesianism"). It is high time for a fundamental shift in economic thinking. There has been a foolish and myopic focus on interest rates. We need a more comprehensive understanding of the powerful impact of money - meaning the quantity of money, nowadays dominated by bank deposits - on our economy and society.