Should the Federal Reserve set a particular “hard” target for inflation and adjust monetary policy to achieve that goal? Or should it determine a “soft” target — something other than inflation, perhaps unemployment — and not be required to dogmatically adjust monetary policy to meet some specific number? In making this choice, should the Fed be concerned about the political backlash over which target it selects?
There’s much talk these days about the concept of inflation targeting, hence these questions. There are many ways of managing inflation, but the practice is best illustrated by the price rule, or the Fed’s policy of determining the federal funds rate — the interest rate charged by banks as they lend to each other — to impact some measure of inflation, such as the Dow Jones AIG Spot Commodity Index. Arthur Laffer, the famed supply-side economist who popularized the idea that cutting tax rates can lead to higher tax revenues, has suggested that the Fed, under Paul Volcker in the 1980s, shifted monetary policy from a quantity rule (attempting to control the supply of money) to a price rule (attempting to control the price of money). Subsequent studies of the relationship among commodity prices, the federal funds rate, interest rates, the stock market, and the economy demonstrated that the Fed indeed shifted to this price rule.
Left out of this analysis, however, is the growth of the money supply. Maybe that’s a good thing. Traditional economists, and monetarists in particular, prefer to believe that inflation is too much money chasing too few goods, and that a policy of raising interest rates ultimately reduces inflation. In the “old” days, prior to the emergence of the price rule, the Fed targeted growth in the money supply to control inflation. The monetary authority would set “bands” within which various monetary aggregates were allowed to fluctuate, and when these bands were penetrated, it would take action by either raising or lowering the fed funds rate to get the growth in money back into the bands. Since the resultant swings in interest rates were substantial, this practice had a negative influence on the economy. But then came the price rule, a less-volatile guide for adjusting interest rates, and with it an era of much smoother monetary sailing.
Still, there’s a problem with the theory that inflation is caused by too much money chasing too few goods: This theory often doesn’t work in the real world, no matter what traditional measure of money is selected. If the theory were ironclad, instances to the contrary wouldn’t exist. But they do.
To get a handle on the concepts of too much money and too few goods, we can look at the growth rate in what is called the “narrow” money supply. This historically popular measure of money can be directly controlled by a central bank that watches over a country’s economic output as measured by real gross domestic product. To be a useful monetary aggregate, this measure should provide the monetary authority with the level, and trajectory, of inflation. For example, if the money supply is growing rapidly while the enonomy is also expanding rapidly, then the resultant inflation could be low. On the other hand, if a monetary authority were flooding the system with this narrow measure of money while no economic growth of any significance was occurring, then high inflation should be the obvious outcome.
But again, this is an imperfect theory, as a recent real-world example shows.
The following chart displays growth in the narrow money supply for an industrial country that implemented a traditional monetary policy between 1993 and 2005 (I use both annual growth rates and a three-year moving average to insure that the distortions of one-year changes are minimized):
The average money-supply growth rate over this period was 9.3 percent, so if this country were one of the fast-growing economies of Eastern Europe or the Far East, one might assume that its money growth was not inflationary. So let’s take a look at the growth in this country’s real economy:
Real economic growth over this period was a paltry 0.8 percent. Money-supply growth of 9 percent per year coupled with GDP growth of less than 1 percent? I wouldn’t fault you if you guessed that this country is a banana republic.
But let’s now look to the consumer price index, which can help verify the theory that inflation is too much money chasing too few goods:
This chart provides evidence that above-average growth in the money supply had virtually no impact on a traditional measure of inflation. In other words, the shocker is that inflation is non-existent in this example, even though there was a demonstrated surge in the country’s money supply and almost recession-like economic conditions.
Finally, let’s take a look at interest rates:
While short-term interest rates are influenced by monetary policy, long-term interest rates supposedly include an inflation premium that will protect long-term bond investors from future inflation. Under this assumption, one interpretation of this last chart is that bond investors were not demanding any real premium for future inflation, even though the money-supply growth appeared to be inflationary.
These statistics reflect economic conditions not in a banana republic or an underground colony on Mars, but in Japan, where the relationship between traditional measures of money supply growth and inflation have failed to occur in recent years. This analysis indicates that either we need another approach for explaining inflation, or that the appropriate target for validating the relationship between the money supply and inflation has not yet been identified.