Earlier today I put out post with ‘one graph’ illustrating just how much behind the curve the ECB is in terms of needed monetary easing. At the core of that blog post was a graph of the ‘price gap’. I defined the price gap as the percentage difference between the actual price level (measured with the GDP deflator) and a 2% path.
David Laidler has asked me how the ‘two graph’ version of the post would have looked. The other graph of course being the (broad) money supply rather than price level.
David, take a look at this graph:
We know from my earlier post that the ECB prior to 2008 basically was able to keep the actual price level very close to the ‘targeted’ price level (the 2% path). Therefore, we will also have to conclude that the actual money supply (M3) level was more or less right. Hence, if we assume an unchanged trend in money-velocity then it reasonable to also assume that the pre-crisis trend is the trend in the money supply necessary to return the price level to the pre-2008 trend.
I define the ‘money gap’ the percentage difference between the actual M3 level and the pre-2008 trend-level. The graph is extremely scary – the ‘money gap’ is now -30%! Said in another way – the ECB needs to expand M3 by 30% to bring prices back to the pre-crisis trend level or the ECB needs to engineer a massive change in expectations to push up money-velocity.
Don’t tell me that the ECB doesn’t need to do massive QE to avoid deflation…
PS I have chosen to ignore commenting on ECB’s policy decision earlier today, but lets just say that today’s action is unlikely to do much about the deflationary risks in the euro zone. Outright QE is needed.
PPS I have earlier discussed the euro zone ‘money gap’. See for example here.
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