Why money supply deserves more Fed attention

A focus on interest rates, some economists argue, ignores a more telling indicator

The Federal Reserve last week ditched "one of the best friends it ever had."

So maintains Paul Kasriel, chief economist of Northern Trust Company, a Chicago bank.

What happened was that Fed Chairman Alan Greenspan did not announce targets for growth in the money supply in the United States in testimony before the Senate Finance Committee last Tuesday.

"It was a mistake," agrees Allan Meltzer, an economist at Carnegie-Mellon University, in Pittsburgh.

Money is the fuel used by the economy in its daily business. Too much of it, and inflation thrives. Too little, and the economy tumbles into recession. Just right, and the economy bustles at a comfortable pace.

Most important, the Fed can control the money supply.

Since the Humphrey- Hawkins Act governing the Fed went into effect in 1978, the central bank has been required to appear before Congress and include its money and credit targets in its economic forecast.

That act expired last winter. Mr. Greenspan, nonetheless, did go before Congress last Tuesday. While not mentioning the money targets, he did make news, as usual. The economy seems to be slowing, he said.

When Fed policymakers meet Aug. 22 to discuss raising interest rates, their decision will hang on whether the latest economic data confirm a slowdown. Greenspan even indicated it may be possible for unemployment to remain as low as 4 percent without pushing up inflation.

A key number released Friday didn't indicate much of a slowdown. Gross domestic product, the output of goods and services, ran at a 5.2 percent annual rate after inflation in the second quarter, up from a revised 4.8 percent in the first quarter. (See chart below.) But inflation, measured by a GDP price gauge, was lower - 2.3 percent versus 3.5 percent. Consumer outlays were also tamer.

Greenspan also said Tuesday the growth of money isn't too useful in forecasting the economy. That view makes some economists nervous.

"The greatest mistakes the Fed has made were the Great Depression [of the 1930s] and the Great Inflation of the 1970s - because it ignored the effects of money growth," says Mr. Meltzer.

Not publishing money targets does not mean the Fed is entirely disregarding the money numbers. At least two regional Fed branch presidents keep close track of those numbers and join in Fed policymaking.

But it does hint that the Fed is deemphasizing money as an economic tool.

Greenspan's action is "overdue recognition" that the Fed manages the economy by its control of interest rates rather than the money supply, says Tom Schlesinger, director of the Financial Markets Center in Philomont, Va.

Once, though, money was the Fed's primary monetary instrument. In October 1979, former Fed Chairman Paul Volcker announced the Fed would limit growth in the money supply - rather than control interest rates - to end double-digit inflation.

The policy worked. Interest rates shot up as high as 20 percent briefly. The economy fell into a bad recession. Inflation plunged.

But soon the Fed reverted to its usual practice of looking primarily at interest rates in implementing monetary policy.

That wasn't necessarily bad. During the 1980s and the early part of the 1990s, money growth didn't predict the economy as well as it had for decades, perhaps because of a banking crisis.

Now, says Meltzer, money growth has reasserted itself as a more accurate predictor of the economy. "The academic evidence is shifting back," he says.

Real money supply, advanced by two quarters, tracks well with real final sales to domestic purchasers, a chart by Mr. Kasriel shows.

Most economists agree that inflation is a result of too much money. But many disagree on money growth's impact on GDP.

As the joke goes: "The First Law of Economics: For every economist there exists an equal and opposite economist."

(c) Copyright 2000. The Christian Science Publishing Society

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