As expected, the Fed’s Open Market Committee voted Wednesday to lower its target for the Fed funds rate. When the quarter-point cut is implemented, very short-term rates will be at their lowest levels in nearly half a century.
It is the 13th cut in an extraordinary 30 months of monetary easing that began Jan. 3, 2001. After Wednesday’s action, the Fed Funds rate will be at less than one-sixth of where it stood at the beginning of the process.
What is truly striking, however, is that this campaign to lower interest rates took place with virtually no discussion of the money supply. We have come full-circle from the late 1970s, when even some small-town weekly newspapers referred to M1, M2 or “the monetary base” on their editorial pages.
For definition purposes, M1 refers to the sum of all currency, demand deposits such as checking accounts and travelers’ checks available or in circulation; M2 refers to M1 plus saving accounts and other time deposits; M3 is M2 plus other investments with easy cash access.
While most economists have concluded that rigid targeting of money supply measures was not a sound way to conduct monetary policy, the current unwillingness to even mention the subject sets us up for eventual public misunderstanding of the whole monetary policy process.
Lack of public awareness of the tradeoffs monetary policy makers face increases pressures to adopt bad policies. Anyone who has taken an introductory economics course knows that for the Fed to lower interest rates, it has to increase the amount of money in circulation relative to economic activity. If it wants to raise rates, it has to constrict the creation of new money.
What the last year and a half shows us is that lowering rates is easy when the economy is slack. If demand for loans is sluggish enough, even modest growth on the supply side suffices to keep rates low.
When the FOMC began to step on the monetary gas pedal in January 2001, M2, a commonly used measure of the money supply, was growing at about 6 percent compared to year-earlier levels. The Fed acted to cut target rates 11 times in that calendar year, lowering its target from 6 percent to 1.75 percent. To accomplish this lowering, it had to push M2 growth up aggressively to more than 10 percent after 9/11.
In 2002, however, it cut rates only one more time, on Nov. 6, to a target of 1.25 percent for Fed Funds.
Reaching this lower level didn’t take much effort at all. The rate of growth of the money supply actually drifted lower from 9.7 percent in January to only 6.6 percent in December. Even though there was less pressure on the Fed’s accelerator, interest rates stayed low because of soft demand for loans.
Despite widespread pessimism about economic conditions globally, the Fed has had to ratchet up money growth in 2003. In May, M2 had grown by about 8 percent compared to a year earlier. (For those who prefer other measures, M1 and M3 grew by 6.21 and 6.7 percent respectively over the same period.)
Readers may well ask themselves why anyone other than economists should pay attention to these details of the money supply. After all, aren’t interest rates what is really important?
The answer is that money does matter. Over the long run, the growth of the money supply relative to the growth of output is what causes inflation or deflation.
Prices increased by more than 500 percent in my adult lifetime because the money supply grew too fast. As long as the economy remains slack, Fed officials do not have to worry about inflation. Indeed, they are boosting the money supply vigorously to avoid deflation or falling prices.
But history shows that 9 percent monetary growth cannot go on forever without adverse consequences. Sooner or later, probably within the next 15 months, the FOMC will have to shift its foot from accelerator to brake pedal. When it does, there is sure to be a political and public outcry.
Any economic policy decision that affects millions of households is inherently controversial. Monetary policy changes are no exception. However, the news media’s complete avoidance of money supply issues contributes to an ill-informed citizenry and, eventually, to unnecessarily controversial Fed actions. We would all be better off if we paid a little more attention to what the Fed really does — controls the money supply — and less to the visible result of money supply changes — short-term interest rates.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.