The Demise of Monetary Aggregates

There once was a time when critics of Fed policy thought the key to good monetary policy was stable growth in the money supply. If the Fed would only keep M1 or M2 growing at a low, stable rate, the argument went, the economy would avoid high inflations, painful deflations, and the major booms and busts of the business cycle. Milton Friedman was the most prominent proponent of this so-called "monetarist" view. (…) Increased reliance on target ranges for the monetary aggregates was allegedly part of Paul Volcker's 1979 change in the direction of monetary policy, which helped set the stage for the 1990s. If the improved macroeconomic performance of the 1990s went hand in hand with greater stability in the money supply, monetarists could have claimed intellectual victory. Alas, it was not to be. (…) One clear fact is that the 1990s saw slower money growth than the 1970s and 1980s. The basic lesson of the quantity theory of money – that slower money growth and lower inflation go hand in hand – receives ample support from this decade. Yet the data give no support for the monetarist view that stability in the monetary aggregates is a prerequisite for economic stability. The standard deviation of M2 growth was not unusually low during the 1990s, and the standard deviation of M1 growth was the highest of the past four decades. In other words, while the nation was enjoying macroeconomic tranquility, the money supply was exhibiting high volatility.

From the standpoint of economic theory, this is not a puzzle. The money supply is one determinant of the overall demand for goods and services in the economy, but there are many others, such as consumer confidence, investor psychology, and the health of the banking system. The view that monetary stability is the only ingredient needed for economic stability is based on a narrow view of what causes the ups and downs of the business cycle. In the end, it's a view that is hard to reconcile with the data. This lesson was not lost on monetary policymakers during the 1990s. In February 1993, Fed chairman Alan Greenspan announced that the Fed would pay less attention to the monetary aggregates than it had in the past. The aggregates, he said, "do not appear to be giving reliable indications of economic developments and price pressures." It's easy to see why he might have reached this conclusion when he did. (…)

Henceforth, the Fed would conduct policy by setting a target for the federal funds rate, the short-term interest rate at which banks make loans to one another. It would adjust the target interest rate in response to changing economic conditions, but it would permit the money supply to do whatever necessary to keep the interest rate on target. If the subsequent performance of the economy is any guide, this policy of ignoring data on the monetary aggregates has proven a remarkably effective operating procedure. (…)

There is a long tradition of concern among economists that a central bank's reliance on interest-rate targets could prove inflationary. (…) Fortunately, there is a simple way to avoid this problem : A central bank should raise its interest-rate target in response to any inflationary pressure by enough to choke off that pressure. (…) it is crucial that the response be greater than one-for-one. These theoretical insights go a long way to explaining the success of monetary policy in the 1990s, as well as its failures in previous decades. (…) In earlier decades, the response was less than one-for-one. In the 1960s, for instance, when inflation rose by 1 percentage point, the federal funds rate rose by only 0.69 of a percentage point. The theory of spiraling inflation may be the right explanation for the Great Inflation of the 1970s. In other words, this episode was the result of the inadequate response of interest rate policy to the inflationary pressures arising first from the Vietnam War and later from the OPEC oil shocks. The situation was just the opposite during the 1990s. Each rise in the inflation rate was met by an even larger rise in the nominal interest rate. When inflation rose by 1 percentage point, the federal funds rate typically rose by 1.39 percentage points. This substantial response prevented any incipient inflation from getting out of control. Although the 1990s saw high responsiveness of interest rates to inflation, it was not a decade of volatile interest rates. (…)

High responsiveness and low volatility may seem a paradoxical combination, but they are easy to reconcile : The more the Fed responds to inflationary pressures when they arise, the less of a problem inflation becomes, and the less it has to respond to later. Overall, the U.S. experience with monetary policy during the 1990s teaches a simple lesson. To maintain stable inflation and stable interest rates in the long run, a central bank should raise interest rates substantially in the short run in response to any inflationary threat.