The Federal Reserve’s Open Market Committee had another meeting Tuesday. Scanning four newspapers Wednesday, I found almost identical stories on the event.
The central bank lowered its target for the federal funds rate by half a percentage point to 2.5 percent, the ninth reduction in 2001.
Yet, none of the stories reported how the nation’s money supply is changing in response to the Fed’s actions—a major oversight. The Fed can lower interest rates only by increasing the money supply.
Let’s review.
Central banks do not control interest rates. They do manage the money supply. They can push interest rates down by increasing the money supply or push them up by constricting it.
When the Fed’s Open Market Committee says it is lowering its target for the federal funds rate, it means that it will create enough new money so that particular interest rate is driven down by half a percentage point.
Central banks do not create or destroy money in a vacuum.
If the Fed increases the money supply too much, the United States will experience inflation. If they do not increase it enough, we suffer from deflation, as we did in 1930-1933 and as Japan may be doing right now. Now, the danger needle is clearly swinging toward the inflation side of the gauge.
The Fed’s campaign of lowering interest rates means they have been consciously increasing the money supply. Through August, M1–a narrow measure of the money supply—rose by 5 percent over what it had been at the end of 2000. M3—a broader measure—rose nearly 8 percent.
Remember, that data came before the events of September 11, the point at which the Fed really began to shovel money into the economy.
The initial September money-supply increases will not be released until October 18. I am sure that the numbers will show one of the sharpest one-month jumps in Fed history.
What is bad about that? Doesn’t the economy need liquidity?
No, nothing is inherently wrong with a one-month sharp increase, and yes, the Fed was certainly right to err on the side of maintaining liquidity, public confidence and the stability of the payments system. Is inflation a present danger? No.
But as economists famously say, there is no free lunch.
History shows that moderate disparities between the growth of the money supply and the growth of real output over limited periods of time are harmless. But it also shows that excessive money growth over an extended period always leads to inflation.
Americans are famous for their impatience. They want results now, whether from aspirin taken for a headache, or from Fed monetary easing to buffer a recession.
But history also shows that changes in monetary policy have few effects until several months have passed—10 to 18 months is the lag many economists cite.
In other words, we are just now getting to the point where the first money-supply increases initiated in January should make their effects known.
Given the shocks of the attacks and subsequent events, the economy is likely to slow for another quarter or more. But a prudent Fed should ease its foot off the gas pedal well before we can measure strong growth.
It will undoubtedly be criticized if it does so, though.
Wall Street gurus whose firms’ portfolios might benefit from inflation will speak out sharply. Populist senators from Minnesota and North Dakota will trot out their standard press releases decrying Fed callousness and incompetence.
Many American will agree with such criticism because they newspapers they read and the television they watch are failing to give them needed information.
Nine decisions to increase the money supply this year probably were justified. September was an extraordinary month in U.S. history, and extraordinary measures were called form. But the longer and more strongly the Fed gooses the money supply, the greater the risk of inflation.
We cut the buying power of consumers’ dollars by 75 percent from 1967 and 1982 because the Fed focused on interest rates and did not pay enough attention to the money supply. That inflation was regressive. It hurt poor families more than rich ones.
If we fall into the same trap of focusing on rates and ignoring the money supply, we could do it again. The media bear the responsibility of keeping us informed.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.