Why Price Hikes Won't Pick Up: 'Slow' Money

Inflation will decline a bit in the months ahead, says economist Allan Meltzer - despite the "yammering away" on Wall Street about a potential for faster price rises.

The Carnegie Mellon University professor makes his prediction on the basis of what economists call the quantity theory of money. Though it sounds arcane, it's at the heart of modern economic theory - and it affects the decisions of Federal Reserve policymakers on interest rates and economic growth.

Using this theory, Dr. Meltzer reckons that growth in the nation's money supply has been slow enough in the last two years or so that there is no room for prices to take off. Economists on average expect an increase in the consumer price index this year and next of about 3 percent, up from 2.5 percent last year.

The equation MV = PT is something every student in an introductory course on economics at least brushes against. It says that the money supply (M - the amount of currency and other forms of money used to buy and sell goods and services) times velocity (V - how fast that money changes hands) will always equal prices (P) times output (T - nominal gross domestic product, the output of goods and services in the nation).

This quantity theory is widely accepted. When the World Bank or International Monetary Fund wants to tame rampant inflation in a nation, their standard advice is that governments not create so much new money. They recommended that path to Russia, where the central bank had been providing agriculture and state enterprises with huge amounts of new credit. When the bank took the advice, the rate of inflation dropped from almost 18 percent in the month of January 1995 to 1.6 percent in May 1996. IMF economists worried that President Boris Yeltsin's moves in June to provide funds to meet various campaign promises would upset this progress on inflation. Similar action shrank inflation in Argentina, Brazil, Chile, and Peru, to name just a few other nations.

So why, asks Meltzer, do so many analysts on Wall Street "put up this drumbeat" that the money supply thesis isn't working?

One reason is that many Wall Street economists figure the growth in money supply has lost some of its power to predict both inflation and growth in output.

Meltzer admits there is "a lot of randomness in the economy." As a result, no forecasting technique "predicts perfectly or even extremely well in the short term," he says. But he maintains that the monetarist forecasts of a group of eight economists that call themselves the Shadow Open Market Committee have been at least as accurate as those of economists using other methods. That group, in existence for more than 20 years, follows closely the actions of the Federal Reserve's policymaking body, the Open Market Committee.

Fed chairman Alan Greenspan raised the eyebrows of Fed watchers two weeks ago when he told the Senate Banking Committee: "The experience of the first part of the 1990s - when money growth diverged from historical relationships with income and interest rates - severely set back most analysts' confidence in the usefulness of M-2 [a measure of money]. Recently, there have been tentative signs that the historical relationship linking the velocity of M-2 - or the ratio of nominal GDP to the money stock - to the cost of holding M-2 assets [savings deposits, money market deposits, etc.] has reasserted itself." So, he indicated, the Fed will be watching M-2 carefully to see if it forecasts output.

That prompted economist Paul Kasriel to characterize the Fed as a "sunshine monetarist." By that Mr. Kasriel, of the Northern Trust Company in Chicago, means the Fed tends to pay attention to the money supply numbers when the policy implication of their behavior matches the policy bias of its policymakers. Since M-2 increased by 4.9 percent in the 12 months ending June 1995, up from only 2.1 percent in the previous 12 months, the Fed would have more excuse to tighten monetary policy now.

But monetarism isn't so simple. Meltzer watches the "monetary base," bank reserves and cash; some others prefer M-1 (a slightly broader gauge of money) or M-2 (broader still). Then the velocity of money - how fast it turns over - is crucial. Wall Street economist Robert Parks calls velocity a "rascal,'' noting that it speeded up this decade but could now slow, causing a recession or a miniscule growth rate even if the money supply grows.

"It is a possibility," says Meltzer. But he's not counting on it.

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