Back to basics
29 October 2012Asset managementLast week Mario Draghi, president of the European CentralBank (ECB), went to the German Parliament to explain whythe actions of the ECB were not going to generate inflation.Some German parliamentarians are going back to basics:since the ECB is printing more money, this could lead tohigher inflation. For them, money printing brings unwelcomeechoes of the German hyperinflation of the 1920s. Mr Draghitold them not to worry.Since the onset of the crisis, many central banks haveembarked on ultra-loose monetary policy. First, they cutinterest rates. Then, when policy rates had been cut to theirlimit they resorted to quantitative easing. The result has beenan unprecedented amount of liquidity injected into most of theadvanced economies. The amount of currency in circulationand sitting in bank reserve accounts has more than doubled asa share of GDP in the last five years (see chart 1).The monetary base affects inflation through the wonders offractional reserve lending. Banks can lend out most of theiravailable cash as loans to the private sector because they onlyneed to keep a fraction back as a reserve. The more cash that isavailable to banks, the higher the potential lending to the privatesector. Too much lending to the private sector could generateexcessive spending and put upward pressures on prices.A proxy for the amount of lending to the private sectorwould be one of the broader monetary aggregates, such asM2 or M3. Chart 2 shows us that, at least in the Eurozone,growth in M3 is not only positively correlated with inflationbut also leads it by about two to three quarters. So does itmean that all this liquidity will eventually lead to a surge ininflation? The answer is probably not while the monetarypolicy transmission in the Eurozone remains impaired.
Senior Fixed Income EconomistUBS Global Asset Management email@example.com
Fixed Income EconomistUBS Global Asset Managementgianluca.firstname.lastname@example.org
Chart 1: Broad base
Monetary base as a share of nominal GDP (%)
Source: Federal Reserve, Bank of England and ECB
0510152025Q3 2012Q3 2007EurozoneUKUS
Chart 2: Common trend
Trend in Eurozone M3 aggregate growth and core inflation
Source: ECB, UBS Global Asset Management. Trend in M3 calculated using a6-quarter moving average.
Core inﬂation (rhs, yoy)M3 (lhs, yoy)Q32012Q32010Q32008Q32006Q32004Q32002Q32000Q31998Q31996Q31994
Last week the president of the ECB reassured Germanpoliticians that the measures taken by the ECB since theunfolding of the sovereign crisis will not ultimately lead toinflation. The amount of liquidity circulating in the Eurozonehas surged in the last five years, increasing the risk ofinflationary pressures. However, because of the deleveragingin the banking sector and the fragmentation caused by thesovereign crisis, it is unlikely that all this liquidity will represent
a serious threat to price stability in the near term.