How liquidity is driving inflation and asset prices

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▪ Over the last two decades China's role as the lead provider of global liquidity has diminished, while the US has stepped up to fill most of the gap. This will matter when quantitative tightening begins in earnest – advanced economies' monetary retrenchment will have more significance for global financial markets. ▪ But we think changes in the effectiveness of monetary policy, plus the mix of monetary and fiscal policy, should dampen some of the shock. ▪ On one side, the money multiplier (a ratio of broader money to the monetary base) has fallen in the US and eurozone since 2020, when the monetary expansion started, as banks have parked money in excess reserves. So the effects of quantitative tightening will likely be proportionately milder than those seen in 2018. ▪ On the other side, fiscal policy has changed substantially during the pandemic crisis – a decided turn towards fiscal exuberance, coupled with a different structure to budget spending. Whereas post‐GFC discretionary fiscal spending was largely aimed at support for the ailing financial sector, post‐pandemic spending has been directed towards social transfers and discretionary spending aimed at supporting household budgets. We've found a noticeable correlation between budget transfers and inflation in the post‐pandemic period. ▪ A combination of higher liquidity with a lower money multiplier should then mean the costs of quantitative tightening are relatively lower in terms of real activity and financial market performance. As for inflation, it's more likely to be restrained by the retrenchment from the fiscal expansion that played a (possibly decisive) role in unleashing it in the first place.