Now that the Fed has decided to increase the money supply for the foreseeable future, investors are placing their bets on the success or failure of such a policy. As I write this, gold has briefly fallen below the price it was at the time of the announcement of QE3. Perhaps gold is trying to tell us something.
I remember when Paul Volcker was appointed to the Fed to combat double-digit inflation. Most remember that he allowed interest rates to seek their own level soaring to around 19%. That kind of penalty rate stopped inflation in its tracks. But few remember the money supply figures of that time.
In 1981 under Volcker's Fed, M2 growth averaged 8-9%. In 1982 it continued to increase at an 8-10% pace. In 1983 the pace of growth went up to 10-12%. Milton Friedman predicted we were in for a bout of renewed inflation because of the increasing money supply, and Alan Greenspan, who was a private forecaster at the time, said, "This time Milton Friedman will be wrong."
Greenspan won that argument as inflation rates fell continuously along with interest rates during those years. Gold also began its long decent from 850 to about 250.
Paul Volcker and his colleagues set money growth in the 8-12% range for over five years, while under the Bernanke Fed, M2 growth has fallen from 10.55% in January 2012 to 6.5% this September.
Ironically, Volcker was fighting inflation as he increased money supply in contrast to Bernanke who has been fighting deflation as he has decreased the rate of growth in money. The Fed balance sheet remains no higher today than it was eighteen months ago (For a detailed discussion on how QE3 has affected the balance sheet click here). By this measure, money growth has been stagnating in a time of very low inflation and economic growth. It is well past time to increase the money supply and the Fed has finally moved to do so.
This notion that we are about to embark on "QE4-ever" is a little puzzling. Isn't a monetary system supposed to expand? Whether on a fiat standard or a gold standard--money increases. It's only a matter of degree. Under the gold standard, the increase is dependent on mine production and imports of gold. Under a fiat system, it is decided by committee.
Milton Friedman called for the Fed to set a consistent and stable money supply to ensure price stability. Ben Bernanke has just agreed with him. We will now have an open, transparent, and steady money supply for as far as the eye can see. This is to be administered within the Fed's mandate of price stability, and the amounts can be lowered or raised if and when necessary. The standard will be a target rate of 2% inflation. I would not be surprised, however to see that raised to 2.5% or even 3%.
I'd be interested to know what Greenspan, who is not a monetarist, thinks of all this. He argued with Milton Friedman that monetary policy must be discretionary. In Friedman's own words:
Over the course of a long friendship, Alan Greenspan and I have generally found ourselves in accord on monetary theory and policy, with one major exception. I have long favored the use of strict rules to control the amount of money created. Alan says I am wrong and that discretion is preferable, indeed essential. Now that his 18-year stint as chairman of the Fed is finished, I must confess that his performance has persuaded me that he is right-in his own case. His performance has indeed been remarkable…There is no other period of comparable length in which the Federal Reserve System has performed so well…
Inflation averaged 3.7% per year from the end of World War II to the Volcker era, but only 2.4% per year during the Greenspan era. Even more important, inflation was much less variable. ... Price stability fostered innovation and supported a high level of productivity. ...
…It has long been an open question whether central banks have the technical ability to maintain stable prices. Their repeated failures to do so suggested that they did not -- whence, in part, my preference for rigid rules. Alan Greenspan's great achievement is to have demonstrated that it is possible to maintain stable prices. He has set a standard. Other central banks around the world, whether independently or by following his example, are following suit. The timeworn excuses for central bank failure to stem inflation will no longer do. They will have to put up or shut up. -Milton Friedman, WSJ, Jan. 31, 2006
Most everyone would agree that the goal of monetary policy is to create price stability. But how to achieve stability is often more art than science. I think most Fed observers today are overestimating the potency of QE. Many are predicting progressive inflation, therefore progressive increases in commodities and stocks. Somehow, I doubt that it will work out that way. Remember, Volcker increased the money supply at 10% rates, way above Bernanke's present 6.5%, and inflation fell.
How will we know whether we are entering a new era of inflation or whether we will be overwhelmed by deflation? Or will we instead achieve the goal of price stability? Do not rely strictly on monetary policy. Watch everything. Most importantly, watch the price of gold. If the Fed has monetary policy right, gold will not soar. It will level off.
If gold does soar however, it will be indicating either further inflation or that something else is amiss in the world such as geopolitical events, unusual central bank buying, or some fiscal "cliff" we may be fast approaching. If gold falls, it may be signaling a return to the recessionary/deflationary bias we just avoided. Gold prices could also drop sharply with credible austerity programs being imposed. Whatever the course, gold has always acted as an age-old warning of things to come. To quote Alan Greenspan once more, "Ignore the price of gold at your own peril."
I suggest we pay particular attention in the months to come.