It’s strange: For many years, the Federal Reserve has conducted monetary policy with little if any reference to the money supply. Fed officials never mention M1 or M2 anymore, and analysts in academia and on Wall Street rarely think about those variables either.
In a new NBER Working Paper, we trace out the developments that led to the jettison of money supply measures from monetary policy deliberations, and we offer some reasons why the Fed and Fed watchers might want to pay renewed attention to money.
Twenty-five years ago, the debate over money’s role in policymaking still raged fervently. Between 1986 and 1988, Allan Meltzer, a founder of the Shadow Open Market Committee, and Bennett McCallum, another long-time SOMC member, both wrote articles proposing rules by which the Fed could stabilize nominal income by controlling the monetary base. Soon thereafter, three leading researchers at the Federal Reserve Board, Jeffrey Hallman, Richard Porter, and David Small, published a paper presenting their famous P-Star model; it outlined a similar strategy through which the Fed could use its influence over M2 to target inflation.
Several key papers from the early 1990s, however, worked to undermine the confidence that economists had in monetary aggregates as guides for monetary policy. In June 1992, Benjamin Friedman and Kenneth Kuttner presented evidence showing that previously strong relationships between money and economic activity weakened considerably during the 1980s. Just a few months later, future Federal Reserve Chair Ben Bernanke and Vice Chair Alan Blinder reinforced these findings by showing that the forecasting power of money was minimized once the federal funds rate was introduced into the framework. The implication of these two studies was that any previous association between money and income was seriously undermined by the financial innovations era of the 1980s. The very next year, John Taylor’s highly influential paper showed how well the Fed adjusted its funds rate target in response to movements in output and inflation during the late 1980s and early 1990s. The debate was closed. A new consensus, prevailing to this day, placed interest rates instead of money at the heart of all monetary policy discussions.
Our paper begins by reconsidering the evidence presented in Bernanke and Blinder’s famous article. We show that across many different episodes, including the 1980s, the money supply regains its predictive power when the Federal Reserve’s official, simple-sum measures are replaced by the corresponding Divisia measures advanced by William Barnett. That earlier results can be reversed merely by using a different measure of money reflects how the Divisia series account for the effects of financial innovations. Unlike simple-sum measures, the Divisia statistics attribute different weights to different monetary assets and, in particular, give less emphasis to newer assets like money market accounts, which pay interest but are less liquid. In doing so, the Divisia aggregates measure more accurately the flow of monetary services from each asset, capturing the effects of financial innovations in a manner that the Fed’s statistics cannot. The logic of this approach is the same as that applied to the construction of the GDP statistics when, for example, a more expensive but more powerful cell phone gets weighted more heavily than a cheaper, more primitive model in terms of the telecommunications services that it provides.
Having observed that measurement matters in gauging the behavior of the money supply, we incorporate Divisia aggregates into a vector autoregressive econometric model to show how Federal Reserve policy actions have always triggered simultaneous movements in both interest rates and money. Thus, to fully account for the effects of a Fed tightening, one must track not just the increase in the funds rate but also the large and persistent decline in money growth that regularly follows.
Why is it so important for the Fed to refocus on money? A final example, discussed more fully in our paper, answers this question. The Federal Reserve lowered its funds rate target to a range between 0 and 0.25 percentage points in late 2008. By itself, this unprecedented action has been popularly interpreted as indicating that an extremely accommodative monetary policy has been in place since then. Our statistical results, however, call special attention to data in the graph below, which reveal that growth in Divisia MZM during 2010 not only declined but actually became negative – a sign of outright monetary contraction. This observation clearly signals that the Fed pulled back too much, too soon, when it suspended its first round of large-scale asset purchases and sent deflationary impulses through the economy; this may have weakened the recovery as well.
Historical evidence and this most recent experience point to the same conclusion. Money still matters for understanding how monetary policy affects the economy.
Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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