There is a captivating logic about the Fed’s recent policy actions. The economy is teetering on the brink of recession. Financial markets are in disarray.
With such uneasiness over the economy’s condition, most observers think it a no-brainer that the Ben Bernanke-led Fed will lower interest rates. After all, isn’t this what everyone expects it to do if spending by consumers and businesses is going to improve?
Other than the fact that previous Fed Chairman Alan Greenspan followed the same policy, there are very compelling reasons why the current chairman should avoid the temptation to emulate his predecessor. The most compelling is something almost no one wants to mention: Money growth is picking up steam.
In the heyday of monetarism — the idea that changes in the growth of the money supply have important effects on the economy — Fed watchers anxiously anticipated the publication of monetary statistics. Over time, however, concern about the money supply waned.
Partly, this was because of uncertainties about the short-term link between money and the economy. Mostly, it was because the Fed reverted to its old ways of controlling short-term interest rates to achieve its policy goals. Isn’t it telling that the Fed abandoned measuring and reporting its M3 measure of money in early 2006?
The Fed relies on adjusting the federal funds rate up and down to fine-tune economic activity. Such blind reliance on interest rates as policy indicators can be problematic. While rates are being pushed lower, the money numbers tell a distinctly inflationary story. Just because the Fed ignores the money supply doesn’t mean that you should.
Over the last several years, the nation’s money supply has expanded at a worrisome rate. A narrow measure of money, known as MZM, increased at a rate less than 2.5 percent in 2005. By 2007, its rate of growth had spiked to almost 10 percent.
Growth of the broader M2 measure increased less dramatically, from about 4.5 percent in 2005 to nearly 6 percent in 2007, although so far in 2008 it has expanded at more than a 12 percent rate. MZM isn’t slowing down, either: During the first few months of 2008, narrow money is increasing at a rate of nearly 30 percent.
These monetary smoke signals should raise concern about future inflation. The noted economist and Nobel Prize winner Milton Friedman quipped that, "Inflation is always and everywhere a monetary phenomenon."
He did not mean that inflation can’t fluctuate in a given month or quarter even if money growth isn’t. After all, the rate of inflation fluctuates with changes in oil prices, food prices or any number of transitory events.
What Friedman had in mind was the kind of creeping inflation that starts at less than 2 percent, as in 1960, and ends up in double digits, as it did by 1980. It is inflation over horizons longer than a couple of months that worried Friedman. And it is why you should be concerned now.
Some argue that financial innovations and regulatory changes can and have disrupted the link between money and inflation so much that money is useless in setting policy. Indeed, Greenspan made this argument back in the 1990s when he jettisoned money supply numbers from policy deliberations.
But the inescapable fact, based on study after study of country after country, is that over time money growth and inflation remain inseparably linked. The inflationary record for the United States and most other developed countries consistently demonstrates this fact.
Is it coincidence that the Chinese government recently announced it was slowing money growth to rein in sharply rising inflation? Is it coincidence that the European Central Bank adopted and uses money growth as one of its policy guides? These policymakers, unlike those at the Fed, understand that money growth provides useful information about the future path of inflation.
The monetary induced inflation signals are flashing red. Sustaining the recent increases in money growth will put the Fed — and the economy — into a predicament: Will the Fed be willing to fight the rising inflation rates that its current policies are producing if the economy has not rebounded sufficiently?
R.W. HAFER IS DISTINGUISHED RESEARCH PROFESSOR AND CHAIR OF THE ECONOMICS DEPARTMENT AT SOUTHERN ILLINOIS UNIVERSITY EDWARDSVILLE. HE’S ALSO A SCHOLAR AT THE SHOW-ME INSTITUTE, A FISCALLY CONSERVATIVE THINK TANK BASED IN CLAYTON.
rhafer@siue.edu
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