Monitoring Money

At E21, Michael Belongia and Peter Ireland write “Jobs Data Show that Fed Should Monitor Money”:

If the temptation to respond to volatile short-run data risks policy mistakes and induces uncertainty, the Fed could shift its focus to data that point to trends in economic activity rather than volatile data that move around this trend.  To this end, maintaining stable rates of growth in the money supply over intermediate and longer-term horizons would control the general thrust of monetary policy and offer indications of whether the stance of policy was restrictive or expansionary. (They show this graph):

Money Growth_1

The graph also shows that M2 growth declined precipitously in 2009 and 2010, suggesting that the Fed pulled back from its expansionary policies too soon after the financial crisis, contributing to the sluggish recovery and low inflation seen ever since then.  Strikingly, this most recent decline in money growth predates the end of the Fed’s first round of quantitative easing: had policymakers paid closer attention to the behavior of the money supply, they might have avoided this costly error.

Since the middle of 2013, Divisia M2 growth has fluctuated between 5.5 and 6.5 percent.  These most recent rates of growth are below those seen in 2011 and 2012; if this trend towards slower monetary expansion continues, it certainly would be cause for concern. On the other hand, the graph also makes clear that 6 percent money growth is still robust by historical standards and, if it continues, will likely support a return of inflation to the Fed’s 2 percent target.  Either way, these money supply figures deserve more attention, as debates continue over the appropriate timing and pace of interest rate increases later this year.

I think their conclusion is a bit optimistic.

The graph below adds the growth rate of the broadest measure of money supply (Divisia M4). Until shortly before the crisis, these two measures “walked hand in hand”. After the crisis they´ve gone their “separate ways”, and M4 is growing much more slowly (and erratically) than before the crisis. And that´s very restrictive once account is taken of the fall in velocity (rise in money demand) that has taken place over the last several years.

Money Growth_2

Therefore, the 2% target is still not in sight!


2 thoughts on “Monitoring Money

  1. Hello Marcus,
    I was wondering, what explantion do you give for the fact that Divisa M4 growth as greater then Divisia M2 between 2004 and 2008, and shortly after the crash it has been smaller till today ? What structurally changed that could explain this? Thanks!

    • This fact tells you that M4 growth is a much better gauge of the monetary policy stance. After 2003, when the Fed adopted forward guidance, at a time the FF rate was at 1% but nominal spending (NGDP) was way below trend, M4 growth began to trend up, and NGDP rose back to trend. The intensity of the fall in M4 growth in 2008-09 is also compatible with the intensity of the fall in NGDP which occured at the time. It seems that when monetary policy is “correct”, both measures of money “stay together”.

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