Follow the money
Aug 8th 1998
From The Economist print edition
Remember monetarism? It may be coming back into fashion
IN THE heyday of monetarism in the early 1980s, economists and traders pounced eagerly on every new money-supply statistic. Most central banks then set formal monetary targets, and so every wiggle in the data was scrutinised for clues to the next move in interest rates. Since then, monetarismthe notion that faster money-supply growth automatically causes higher inflationhas fallen out of favour. As the link between money and inflation appeared to crack, most central banks long ago abandoned monetary targets.
Now, however, money may be regaining its importance. The Federal Reserve has started to pay more attention to the rapid growth in Americas money supply. And next month the European Central Bank (ECB) is expected to announce it will adopt a target for money-supply growth when Europes single currency, the euro, is launched next January.
Among the big economies, only Germanys Bundesbank currently sets a formal target under which the central bank tries to control the money supply. Most other countries pursue inflation targets (where interest rates are set to bring forecast inflation within a target range), as in Britain and Sweden, or an exchange-rate target, as used by members of Europes exchange-rate mechanism. Americas Federal Reserve has no explicit target for monetary growth, inflation or the dollar, but instead scrutinises a broader range of indicators to keep inflation down.
The money supply is useful as a policy target only if the relationship between money and nominal GDPand hence inflationis stable and predictable. The way the money supply affects prices and output depends on how fast it circulates through the economy. Annoyingly, its speedwhich economists call the velocity of circulationcan suddenly change, as has happened in most economies over the past decade or so as a result of financial innovation and deregulation. For instance, after behaving in a fairly predictable way during the 1980s, the velocity of Americas broad money supply increased sharply in the early 1990s, sending such monetary measures out of fashion as compasses by which to steer policy.
Now, though, there is evidence that velocity has stabilised. Alan Greenspan recently noted that a more predictable relationship may once again be developing between money, economic output and inflation. Some members of the Feds Open Market Committee are also focusing more on money. At its May meeting, William Poole, president of the St Louis Fed, and Jerry Jordan, president of the Cleveland Fed, both dissented from the committees decision to leave interest rates unchanged. They argued that rapid money growth signalled the need to raise rates to prevent a pick-up in inflation.
Americas M2 measure of money (largely cash, cheque accounts, savings deposits, and small time deposits) has risen by 7.3% over the past year, its fastest annual rate for a decade. This used to be the Feds favourite measure, but some economists prefer a broader measure: M3 (which also includes large time deposits and institutional money-market mutual funds) rose by 10% over the same period (see chart). The recent spurt in both measures of money suggests that the American economy remains strong, probably too strong.
The Fed would be foolish to ignore rapid money growth completely (and, being far from foolish, it is not). But few economists would recommend that it adopt a rigid money target. In September, the ECB must decide on the shape of its own monetary policy. As a new central bank, it needs to set some sort of nominal anchor to help build anti-inflationary credibility. It is considering two options: a monetary target or an inflation target. The Bundesbank has been pushing hard for a German-style money-supply target, supplemented, perhaps, by some sort of long-term inflation yardstick.
Several economic studies suggest that while the link between money and inflation has proved fickle in individual countries, pan-European measures of money are much more stable and a good indicator of growth and inflation in the region as a whole. One reason is that, in closely integrated economies, firms and individuals tend to switch between currencies in response to interest-rate differences, an option that will shortly disappear for European countries that adopt the single currency.
Still, what was true in the past may not hold in the future. The shift from national currencies to the euro represents a huge structural change. Combined with the liberalisation of financial markets, this may cause big changes in the behaviour of firms and individuals, and hence the previous relationship between money and inflation is likely to break down. In the early years the euro money supply is therefore likely to be unstable.
The Bundesbank has set an annual monetary target since 1974 and its inflation record is unmatched, so it is understandable that it is keen for the ECB to follow suit. But in almost half of the 24 years the Bundesbank has missed its target, often because of distortions in the money numbers. Indeed, on several occasions the Bundesbank cut interest rates even though money growth was above target.
In practice, therefore, the Bundesbank does not actually pursue a pure monetary target. Because of its long track record of delivering low inflation, occasional overshoots have not undermined the German central banks credibility. The European Central Bank, however, starts without this advantage. Establishing such credibility will prove hard if it sets a monetary target and then is promptly forced by unforeseen events to overshoot it. This is why the ECB would be better advised to adopt an explicit inflation target, along the lines of those used in Britain, Canada, New Zealand and Sweden. The Bank could then be judged by its results.
The money supply can often be a useful early-warning signal. A wise central banker, like a wise driver, should regularly check the speedometer. But a driver who stares solely at the speedometer is likely to have a nasty crash. Likewise, central bankers need to monitor a large range of economic and financial indicators if they want to be sure of achieving their ultimate goal of low inflation.