Is inflation caused by deteriorating inflation expectations or excessive monetary growth?

Abstract

AbstractThe near‐universal practice of inflation targeting has strengthened the belief of central banks that all that is needed to control inflation is to anchor expectations with a credible inflation target. The use of Taylor rule augmented DSGE models for policy analysis and forecasting adds credence to the view that, provided inflation expectations remain stable, actual inflation will be driven by expectations. The ultimate drivers of inflation are subsidiary to the central bank operation of acting on inflation expectations for the control of inflation. This article poses the question whether inflation is caused by deteriorating inflation expectations or excessive monetary growth. It takes as its theoretical inspiration Friedman's theory of nominal income determination. We use quarterly data of one‐year‐ahead inflation expectations produced by the Bank of England, and medium‐run inflation expectations backed out of five‐year bond yields as measures of long‐term inflation expectations. To this we add actual inflation, nominal GDP, and M4 to define a four‐variable VAR. The results reveal that M4 Granger causes inflation and inflation expectations, and a variance decomposition of inflation shows that while inflation expectations help to drive inflation, after a period of between five and eight quarters money supply dominates the variance decomposition.