The Bank of England is behind the monetary curve again. Last week the monetary policy committee’s two most hawkish members switched from voting for interest rate hikes to leaving the Bank rate unchanged at 5.25 per cent, signalling a pathway to future policy softening.

Yet beneath the headline 3.4 per cent annual inflation rate, prices have already flatlined since last September. An overly tight monetary stance looks all set to deliver below-target inflation, and possibly even deflation — errors the Bank could have avoided.

Economists who take the money supply seriously are aghast. Back in early 2021, the monetarist Tim Congdon showed that the quantity of money had grown by a massive 15 per cent in the pandemic’s first year, the fastest growth in four decades. Given it takes a year or two for extra money to affect prices via people’s spending, he predicted a sharp rise in inflation in 2022. And rise it did, peaking at 11.1 per cent that October, far above the Bank’s 2 per cent target.

This past year, we’ve seen the opposite error. The broad money supply data — specifically, the M4x series that the Bank itself publishes — suggests monetary policy is too tight to ensure inflation hits its target in future. The quantity of money contracted by 4.2 per cent in the year to September 2023 and still sat 3.2 per cent below its peak in January 2024. An outright shrinking like this is unprecedented since the series’ inception in 1998, a period which includes the global financial crisis.

Through the 2010s, a money supply growth of about 3.5 to 4.5 per cent a year was broadly consistent with inflation remaining at target. The Bank has overseen annual money growth below this range since February 2023, with the money supply shrinking since last August. Per the quantity theory of money, championed by Milton Friedman, less money chasing goods and services will lead to trend inflation falling, with outright price deflation possible in 2025.

Monetarists explain that asset prices are often a canary in the coal mine, given that they react more swiftly to money supply changes. There, the signals aren’t great either. The Nationwide house price index, though recovering slightly recently, fell by 1.8 per cent in 2023; the FTSE 250 index of company shares has performed poorly too, still sitting 18 per cent below its August 2021 peak.

Monetary policy ultimately affects inflation through its impact on total spending. Between the third and fourth quarter of 2023 nominal (or cash) GDP — a metric functionally equivalent to total spending on final goods and services — actually fell slightly. This is notable because, before the pandemic, 3.7 per cent growth per year in nominal GDP was roughly consistent with on-target inflation. Having missed the monetary cues for inflation’s take-off, a host of indicators thus suggest the Bank is squeezing the money supply too hard.

Now, some cling to the narrative that the pandemic and war in Ukraine fully explain inflation’s surge. Might these supply shocks unravelling explain inflation’s decline too? While both mechanisms sound intuitive, temporary supply shocks, unlike excess money creation, can’t explain why nominal GDP surged to about 5 per cent above its pre-pandemic trend by mid-2023. At the very least, excessive Bank stimulus greatly exacerbated inflation.

Likewise, if improved supply conditions were driving inflation down today, we would expect real growth to be strong, rather than the economy simply flatlining. The monetarist explanation better fits the facts: the Bank has overcompensated for allowing high inflation with an excessively tight monetary policy that now risks below-target inflation.

The 1980s showed that targeting the money supply was itself fraught with difficulty. Given changes in the velocity with which money circulates, there’s no simple mechanistic policy relationship between money and prices. Yet the sheer volatility in the money supply indicates macroeconomic mismanagement from the Bank. If the MPC wants to anchor prices, it must start taking money seriously again.