Should We Care About Strong Money Supply Growth?

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One quite often sees commentators pointing to money growth as proving some point or another (although money's popularity as an indicator has been in a secular bear market). Although I would like to abolish money from economic theory, that does not affect how money behaves in the real world. Despite not being of any particular theoretical interest, the "money supply" numbers (M0, M1, M2, etc.) might be useful for economic forecasting. I do not see much value in money data for the developed countries, but that does not rule out someone else finding some useful relationships. Nonetheless, that is not particularly special - there are many other economic variables that have useful a useful lead/lag relationship with the economic cycle

Current Money Growth Is Strong

As an example of the use of money as an indicator, former Fed Chairman Alan Greenspan has been pointing to strong money growth as a sign of incipient inflation risks. A Bloomberg article describes a radio interview with Greenspan as:

"The very early stages are becoming evident," with unit labor costs beginning to rise and money supply growth starting to accelerate, he said.

As a disclaimer, I did not listen to the full interview, so I do not know exactly what Greenspan was looking at. I am not particularly interesting in his thought processes on this question - I am more interested in the general question of the usefulness of money supply data.

The chart above shows data associated with the M2 monetary aggregate for the United States (after adjustments by the St. Louis Federal Reserve). The latest annual growth rate was just over 7% in July, which is well above nominal GDP growth. Is this a signal that inflation will pick up?

How Can Money Be Used In Forecasting

My assumption is that we want to use money growth to forecast economic variables that interest us (such as nominal income growth, or inflation). Some might disagree with that assumption, and that they believe that rapid money growth by itself is significant. However, that still leaves the question - why do we care about money growth in the first place, other than its alleged effect on other economic variables? We then end up once again needing to see whether money growth has any useful information.

I would argue that a monetary aggregate (such as M2) could potentially be used as a forecasting tool in a number of ways. We could try to forecast a number of variables, such as the nominal GDP growth rate or inflation. I will just refer to whichever variable as the "target variable." In the order of the strength of usefulness, these include:

  1. Being able to make numerical predictions of the target based on money growth (or the level of money).
  2. We cannot predict the level of the target, but we may find that changes in the growth rate of money lead the target variable.
  3. Money growth is a good quality coincident indicator of the target variable.
  4. We can slightly improve the fit of a multivariate recession by adding the monetary aggregate to the inputs.
  5. Money growth is correlated with the economic cycle, but has no stronger relationship than any other randomly selected economic variable.

Yes, But Is It Useful?

The first level of usefulness relies upon there being a stable relationship between the monetary aggregate and the target variable. If the target variable is GDP, if "velocity" were nearly constant (or has strong mean-reverting properties), money would qualify for that level of strength. (One could imagine a more complicated relationship between money growth and nominal GDP, but it would be hard to support theoretically.)

If we look at the chart at the top of this article, we did see a relatively stable velocity of money. In the second panel, the fact that (adjusted) M2 was largely confined to the 52.5-60% range of GDP from 1960-1992 is highlighted. (This percentage is the inverse of velocity, but it is more sensible way of looking at the ratio. It fits in with the notion of a stock flow norm.) Even if the two variables diverged in the short term, we know that such divergences cannot be sustained - assuming the velocity remains in this range. (One could argue that the fundamental error of Monetarism was making that assumption.) However, as we see in the post-1992 era, M2 was not preordained to stick with that narrow range.

Once we allow the velocity of money to vary a lot, we have almost no information about the relative growth rates of money and GDP. Money could grow faster than GDP for decades without nominal GDP demonstrating any tendency to "catch up" - which is exactly what has happened in the post-2000 era.

(I looked at M2 and not narrower monetary aggregates, as Quantitative Easing blew those aggregates out of the water.)

If we turn to the weaker uses of money in forecasting, the picture is more muddled. I will be writing about this at greater length in my next book, but I just want to highlight why I am not enthusiastic about such uses of monetary aggregates.

  1. There is a large number of monetary aggregates to choose from.
  2. Fans of money in economics make any number of ad hoc adjustments to the raw money data numbers, for any number of reasons.
  3. There are a large number of target variables to look at.
  4. We can apply any number of statistical transformations to the data before starting the comparison. (For example, we can look at "real" money growth, which means we have the added flexibility of choosing which inflation index to apply to the data.)

Given this level of flexibility, is there any reason to believe that we could not mine through the data and find some form of relationship?

Although I am not completely averse to the use of monetary aggregates in these circumstances, my feeling is that they are not more useful than any other credit aggregates. Furthermore, the use of credit aggregates is probably safer than the monetary aggregates. Monetary aggregates are a fairly arbitrary hodgepodge of instruments. (Why would we expect that there is any useful information in the sum of currency in circulation and required reserves? For example, the monetary base in an environment with no excess reserves consists of currency and required reserves, two instruments that make little sense to aggregate, [Updated, since the original was probably too cryptic.]) If we look at credit data, we are more likely to have a cleaner read on what is actually happening within the economy.