Maybe money supply, not inflation, is the real question faced by Fed

Perform the following experiment. Ask five colleagues whether they think the Federal Reserve should raise interest rates. Then ask them whether they think it is a good idea for the Fed to allow the money supply to grow more than twice as fast as output of real goods and services.

I’ll bet that at least three or four of the five will answer no to both questions.

That illustrates the quandary that the Federal Reserve’s Open Market Committee faces at its meeting this week. There are few signs of inflation, and the public seems convinced there is no need for a rate hike. But the money supply is growing like a weed.

The experiment also demonstrates that after a bitter bout of inflation in the 1970s and 1980s, American citizens have not learned a lot. We are again focusing on interest rates to the exclusion of other factors that are integral to prudent policy.

So it is time for a reminder. The Fed does not set interest rates. Contrary to what most of the media and the public apparently think, the Fed does not set any important interest rate: not the prime rate, not mortgage rates, not consumer credit rates.

The Fed does set one rate, the discount rates for loans from the Fed to commercial banks. But it is symbolic; hardly any money goes out the Fed discount window anymore. The Fed also announces a target for the fed funds rate, the market-driven rate that banks charge each other on short-term loans of excess reserves.

But the fed funds target is only a target. The Fed cannot tell banks what to charge each other.

What it can do is change the amount of money in the economy. That is the tool that it uses to nudge the fed funds rate up or down toward the announced target. To lower the market fed funds rate, the Fed injects new money. To raise the rate, it takes money out of the economy.

To the average person, it sounds like sophistry. Isn’t manipulating the money supply so as to change interest rates the same thing as setting interest rates?

No, it is not! There are many interest rates, short-term and long-term, on safe loans and on risky loans. Fed influence over the money supply is an important variable in market determination of these rates, but many other factors of supply and demand also enter the equation.

Moreover, focusing on Fed setting of interest rates, rather than on Fed influence on the money supply, leads people to frame policy questions the wrong way. Wall Street pundits and the media ask, “Why should the Fed raise interest rates when there is scarcely any sign of inflation?”

Instead, they need to ask, “Should the Fed continue to let the money supply grow at rapid rates when the economy is hot, unemployment is at near-record lows, and there is some evidence that excess liquidity is contributing to a bubble in stock and real estate prices?”

For decades, economists called monetarists argued that if you let the money supply grow faster than real output for a substantial length of time, inflation would result. Hence, a central bank should set a rate of long-run growth of the money supply equal to the long-run growth of real production of goods and services. The money supply would grow to meet the needs of a growing economy, and there would be no inflation.

While monetarists never dominated economics, their ideas were influential.

Policymakers, academics and the media paid a lot of attention to the money supply through the 1970s and 1980s. But a number of financial innovations, including NOW accounts, blurred the line between long-term and short-term deposits.

Together with more sophisticated corporate cash management, these innovations changed the velocity of money–how many times the money supply turns over in a given period. With changing and unstable velocity, existing measures of the money supply lost their usefulness as a guide to monetary policy.

However, the fact that few economists believe that money supply numbers by themselves serve as a reliable guide for Fed policy doesn’t mean the money supply has become irrelevant.

Prolonged growth of the money supply at a rate well above the growth of real output leads to price increases somewhere, in real property or equity values, if not in consumer prices.

Output in the United States is growing strongly, but the money supply is growing more than twice as fast, averaging over 8 percent growth in each of the last two years. Such growth need not lead to economic catastrophe, but society at least should include it in popular policy discussions.

© 1999 Edward Lotterman
Chanarambie Consulting, Inc.