The Federal Reserve has reached an inflection point. As they complete the last rounds of their bond-buying programs, Federal Open Market Committee members must now decide how quickly to bring short-term interest rates back to more normal levels from their current settings of near zero.
Thanks to informative statements, both in the minutes of FOMC meetings (such as those released today) and in speeches given by individual members over the past several months, we now have a very clear idea of how Fed policymakers plan to make these important interest rate decisions. Specifically, the FOMC intends to monitor a wide range of macroeconomic indicators, mostly describing the health of the American labor markets. So long as these various measures of employment and unemployment, labor force participation, and wages continue to improve, the FOMC will respond, slowly but surely, by moving interest rates higher. More rapid improvements may trigger faster adjustments in policy rates; but, conversely, disappointing news will be taken as reason to pause, to let the process of policy normalization proceed more gradually and avoid putting the economic recovery at risk.
One can easily admire the skill, care, and good judgment—much of it supplied by highly-talented Fed economists who supply the FOMC with the “real-time” analysis it needs to support its decisions—that is required by this data-driven approach to monetary policymaking. But one might also feel more than a bit uneasy with a framework that puts so much weight on labor-market variables in the policymaking process.
The reason for unease is that this approach of tying policy decisions so tightly to the behavior of unemployment and other measures of labor market “slack” is one that has failed the Fed—rather massively—in the past. During the 1970s, Fed officials consistently overestimated the amount of excess capacity present in product and labor markets. As a result, they chose settings for interest rates that, in retrospect, were quite often much too low. Tragically, the Fed’s overexpansionary policies did little to improve labor market conditions; instead, they led only to higher and higher rates of inflation.
Thus, one might wish that the FOMC would augment its careful and detailed analysis of labor markets with an equally careful and detailed analysis of monetary conditions. Such an analysis would build directly on the classical theory of inflation—sometimes called the “quantity theory of money” —that associates inflation with excessive growth in broad measures of the money supply. Milton Friedman famously summarized the implications of the quantity theory with his dictum that “inflation is always and everywhere a monetary phenomenon.” What Friedman meant by this statement is that it does not really matter if unemployment is rising or falling, or if interest rates are high or low—Inflation will occur whenever the central bank allows the money supply to grow too quickly and, conversely, deflation will occur when there is insufficient growth in money.
To show just how useful the quantity theory can be in gauging the stance of monetary policy in real time, the figure below plots annual rates of money growth in the United States and Euro Area over the period before, during, and since the financial crisis of 2007-2008 and the severe recession that followed. The graph shows that both central banks—the Federal Reserve and the European Central Bank—allowed money growth to collapse dangerously in 2009 and 2010, hoping, perhaps, that the world economies would bounce back more quickly. Instead, slow money growth in the United States and outright monetary contraction in Europe surely prolonged the period of very low inflation and probably contributed to the sluggishness of the recovery of both economies as well.
Money growth in the United States and Euro Area. The blue line plots year-over-year growth rates of the Divisia M2 monetary aggregate for the US, made available by the Center for Financial Stability. The red line shows year-over-year growth of the official M3 monetary aggregate for the EA, taken from the Federal Reserve Bank of St. Louis’ FRED database.
Shockingly, in the Euro Area, money growth to this day really has not recovered at all. The quantity-theoretic approach strongly suggests that the ECB will have to take more decisive action in the months ahead to generate the kind of money growth that is needed to bring inflation back to its target level. In the meantime, Europe’s recovery will continue to lag our own.
For the United States, however, the news is quite good. The money supply has been growing at consistent, healthy rates for the past several years now. “Quantitative easing” has done its job, and the Fed can continue to normalize its policies as inflation returns to target and the recovery continues to strengthen. From here, a noticeable acceleration in money growth would serve as a warning signal that policymakers are falling behind the curve and need to tighten more quickly lest inflation overshoot its two percent target. On the other hand, another marked decline in money growth would signal that the Fed is moving too fast and needs to pause en route to higher interest rates. Observations of money growth provide a useful cross-check—an invaluable tool to help the Fed chart its course as it treads through unmapped territory.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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