Monetary Policy Remains Potent

by: Bob McTeer

Most central bankers view monetary policy as influencing the rate of growth of the money supply to achieve their objectives. For a while after October 1979, the FOMC tried to control the money supply directly through open market operations and the Thursday money data was watched with great interest. Eventually, the week-to-week money supply numbers proved too erratic to target directly (the demand for money balances became less stable); so, the FOMC reverted to its prior practice of controlling money through its target Federal Funds rate.

The issue was what was the most expedient operating control mechanism; the growth in the money supply continued to be what mattered most for the economy, especially inflation control. Hence, Milton Friedman’s famous mantra: “inflation is always and everywhere a monetary phenomenon.”

In classroom terms, if the central bank wants total spending for goods and services to match the economy’s potential to grow in real terms. Using the equation of exchange for reference, MV=PQ, if Q (real output) can grow around 4 percent per year without inflation building up and without a recession resulting from weak demand, then the recipe for stability in P (the price level) is for MV to grow 4 percent per year. If V (the income velocity of money which reflects the demand for money) is fairly steady, then M (money) growth should be 4 percent.

If V shows a tendency to grow over time, or shrink over time, the money target should be adjusted accordingly to keep MV (total spending) in line with the noninflationary real growth potential of the economy.

I know this is overly simple, but it is useful in thinking about recent policy issues. Sable monetary policy does not mean no growth in money; it means slow growth in money. If the Treasury is financing a deficit by issuing securities, it is normal and correct for the Fed to “monetize” enough of the debt to hit its predetermined money growth targets. More than that–say, in an effort to hold interest rates down–would represent an inflationary monetization of the debt. Thus in today’s world it isn’t appropriate to treat a small amount of Fed purchases (enough to keep its balance sheet from declining) as an inflationary monetizing of the debt.

When the Fed purchases more Treasury securities (or anything else) faster, downward pressure is placed on interest rates while upward pressure is placed on money growth. Most academic economists, I believe, follow Milton Friedman’s lead and regard the latter as more significant over time than the former. Hence, when the target Fed Funds rate reached an effective zero rate, the Fed was not out of tools. Its main tool remained. Monetary policy remains potent.

That last sentence is not contradicted by the fact that the recovery remains weak. Truth is that, while rates were lowered and bank reserves were created, money growth over the past year has remained moderate–perhaps too moderate for the circumstances. Faster money growth has been needed.

It’s been said that you can lead a horse to water, but you can’t make him drink. (Reserve creation has not led to sufficient money creation.) If so, the proper solution isn’t to take the water away. It’s been said you can’t push on a string. The proper solution to that isn’t to pull the string in the opposite direction. In general, if the correct policy isn’t working well, an opposite and indirect policy isn’t the likely solution.

The FOMC’s decision to limit the shrinkage of its balance sheet is modest indeed, since allowing any shrinkage is, in effect, a tightening of monetary policy. They didn’t adopt easy money; just less tight money.

People argue that other things are more important in getting the economy moving again: removing the threat of major tax increases; removing the threat of major regulatory burdens, etc. Okay, but fixing those things are not an alternative to monetary measures. They are a complement. Do both. It really doesn’t matter which would be the stronger medicine.

It is important to remember that the Fed did not ease monetary policy yesterday. It acted to limit the tightening that would automatically have taken place with the run-off of mortgage backed securities. It may not be enough. We need gradual growth in the balance sheet to support gradual growth in the money supply.