All year long, Federal Reserve policymakers have trumpeted plans for “liftoff,” the time when they finally increase their target for the federal funds rate above the range between zero and 25 basis points that has been in place since 2008. To their apparent dismay, that liftoff has been delayed again and again.
Initial plans for a summertime rate hike were pushed into fall while policymakers waited to see whether a weak first-quarter GDP report reflected harsh winter weather or marked the start of a more persistent slowdown. Then, at their September meeting, Fed officials voted to postpone again, citing concerns over economic turmoil abroad. Several, including Chair Janet Yellen, subsequently emphasized that they still expect to raise rates before year’s end. Last Friday’s disappointing employment report, however, may have dashed those latest plans as well.
Ex ante, the Fed’s decision to offer “forward guidance” was intended to help decision-makers plan adequately for changing monetary conditions. Ex post, it appears to have done more harm than good. Repeated talk of rate increases without any follow through has clouded, not clarified, the economic outlook. What can be done to clean up this mess?
One possibility would be for Fed officials to deemphasize the myriad high-frequency indicators – including monthly movements in employment and weekly fluctuations in asset prices – that feature so prominently in their statements and point, instead, to more persistent movements in variables over which they have greater control and also are more tightly linked to their longer-term goals. The quantity theory of money provides a coherent framework in which this can be done. The quantity theory describes how the Fed, as our central bank, serves uniquely as the creator of base money – bank reserves plus currency – and how, by changing the monetary base, the Fed affects the growth rate of broader monetary aggregates and the two components of nominal spending – real GDP and the price level – that span both sides of its statutory dual mandate.
A common misconception is that the quantity theory no longer applies because the Fed has, through multiple rounds of quantitative easing (QE), greatly expanded the monetary base without causing inflation to rise proportionately. What this popular view ignores is that, by paying interest on reserves since 2008, the Fed increased banks’ demand for reserves, partially or even entirely offsetting the increase in supply brought about by QE. This follows from basic economics: both supply and demand must be considered when tracing out the effects of any policy change.
In recently-published work, John Tatom proposed and tested a way to net out the effects of the Fed’s offsetting policy actions. To do so, he computed a suitably “adjusted monetary base” by subtracting excess reserves – the component that has grown most quickly as a result of the Fed’s interest-on-reserves policy – from the sum of total reserves and currency. The graph below plots Tatom’s adjusted monetary base, together with a broader measure of the money supply: Divisia MZM, a weighted average of assets of “zero maturity” that can be converted directly into a medium of exchange.
The adjusted monetary base and Divisia MZM move together, providing valuable information about monetary trends. Strikingly, these quantity-theoretic data do not support the widespread view, based on observations of interest rates alone, that US monetary policy has been extraordinarily accommodative during, before, and since the recession of 2007-09. In particular, both measures of money show signs consistent with systematic monetary tightening in the years leading up to the latest recession – just as declines in their growth rates presaged each of the two previous recessions in 1990 and 2001. Additionally, both measures of money growth plummeted in 2010, potentially accounting for some of the sluggish growth and slow inflation the US has experienced since then.
Fed officials could point directly to these quantity-theoretic observations to highlight the risks of a premature tightening that might derail the recovery and send inflation further below their two percent target. They also could point to the gradual slowing of money growth since 2012 as a sign that their actions already have produced tighter monetary conditions.
More generally, by emphasizing intermediate-term trends in measures of money, Fed officials would no longer be gambling that the next data release will increase confusion about when or if a monetary policy change will occur. Whereas its “data-dependent” approach to policy decisions appears to have increased uncertainty and associated volatility in financial markets, a rising trend in money growth, if observed, would signal clearly that policy should be tightened to avoid higher inflation; further monetary deceleration would support decisions to postpone rate increases further. The quantity theory, by focusing on longer run trends rather than volatile month-to-month changes in multiple indicators, would work as a more reliable guide to monetary policymaking.