The Federal Reserve’s policy statement, to be released immediately following this Wednesday’s meeting, will likely show further signs of dissension within the Federal Open Market Committee. Indeed, debates between Committee members may well intensify in coming months over the appropriate timing and speed with which short-term interest rates will have to rise off their zero lower bound beginning next year.
Open debate, however, is the hallmark of a well-functioning institution operating within a healthy democracy. A leader less capable and confident than Federal Reserve Chair Janet Yellen would surely feel threatened and act deliberately to silence those who disagree. Instead, Chair Yellen earns our respect and admiration for allowing both sides of any argument to be thoroughly aired before taking policy actions that affect us all.
Disagreement within the Fed is inevitable, too, given the difficult challenges that monetary policymakers face today. Considerable risks lie on both sides. If policy is tightened too rapidly, it will jeopardize an economic recovery that is still far from complete and that remains fragile in many ways. But if policy fails to move fast enough, inflation will overshoot the Fed’s two percent target. Some Committee members find it tempting to risk error on the upside, accepting greater potential for higher inflation in order to maximize the odds that unemployment will continue to fall. But other members warn, quite rightly, that the benefits to such a strategy may prove illusory, since a significant period of slow growth or even outright recession may be needed, further down the road, to bring inflation back down if it is allowed to overshoot today.
One of the FOMC’s biggest concerns in recent weeks involves the slowing economies of Europe, which appear to be heading back into decline. Indeed, this threat is very real: Europe is in serious trouble. As I point out in an earlier commentary and discuss further in a paper I’ll present at next week’s meeting of the Shadow Open Market Committee, broad measures of the money supply in Europe have shown very little growth, extending all the way back to the beginning of 2009. Although popular discussions characterize the policies of the European Central Bank as being highly expansionary based on the observation that interest rates are quite low, statistics on the money supply tell a very different story. In Europe, slow rates of money growth have and continue to be a strong source of deflationary pressure. Unless the ECB can find a way to generate more rapid expansion of the money supply, most likely through large-scale purchases of sovereign debt instruments, inflation in Europe will not return to the two percent target. And the longer this period of low inflation and sluggish growth continues, the more likely it becomes that individual countries will decide that they can no longer afford to be part of the Euro area. The dream of a unified, peaceful Europe may well be come to an end.
In choosing between monetary policy alternatives, however, it is important that FOMC members maintain a balanced perspective, giving due weight to the good news as well as the bad. Everyone must now acknowledge that the United States economy has come a long way in its recovery from the recession of 2007-08. Unemployment stands below 6 percent, and real GDP grew at an annual rate of more than 4.5 percent in the second quarter. These are impressive numbers that point to further improvements yet to come. Good news, too, is provided by the sharply declining price of oil, which will help many Americans save money at the gas pump and when heating their homes this winter.
Most importantly for the Fed, however, monetary conditions in the United States could not be more different from those in Europe. As I also discuss in my forthcoming SOMC paper, US monetary aggregates have grown at healthy rates for the past several years. In our ongoing research, also summarized in the SOMC paper, Michael Belongia and I confirm that the links between money growth and the overall economy described more than 50 years ago in pioneering work by Milton Friedman and Anna Schwartz continue to appear in the most recent data. But, our research also shows that it takes time for changes in money in money to impact fully on GDP and inflation. That last observation suggests that the US economy will continue to pick up steam and that inflation, here, is indeed on its way back to the two percent target.
For now, debate within the Federal Open Market Committee ought to be viewed as positive. But accelerating money growth is a clear sign that monetary policy is now providing considerable support to the American economy. Interest rates may have to rise sooner and more quickly than many – including FOMC members themselves – currently expect.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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