Slight Tightening of Monetary Policy Needed to Keep Lid on Inflation

Monetary policy has, once again, been the subject of lively criticism and much hand-wringing.

The critics’ main complaint, as President Clinton takes control of the economy’s levers, is that because the Federal Reserve has been too stingy, monetary growth has been too slow. They claim that sluggish money growth deepened the recession, slowed the recovery and continues to retard growth, jobs and prosperity.

These are serious charges.

Are they true?

The long-term relation between money growth and the growth of current spending is one of the best-established facts of economic history. Periods of rapid money growth are generally followed within a few quarters by rapid growth of spending and production. If rapid money growth continues, inflation follows within a year or two.

The same sequence works in reverse. Efforts to slow inflation only succeed if money growth is lowered. The first effect of slower growth is usually on production and spending. Later inflation falls.

While this long-term relation has been confirmed in many countries and at different times, there is much short-term variability in the relation. Economic researchers have not been able to pin down the short-term effects with anything like the precision of the long-term effects of money on spending and prices.

Criticisms of current monetary policy must be read in this context.

Many of the criticisms are directed at the recent slow growth of a particular measure of money known as M2. M2 is a relatively comprehensive measure that includes currency, checking deposits and various time and savings deposits, including certificates of deposit held mainly by households.

If M2 growth is sending a correct signal, past relationships suggest that today’s sluggish M2 growth will abort the recovery.

But I do not share this view, for two reasons:

* First, the short-term relation between M2 growth and spending has always been subject to large fluctuations. There is nothing particularly striking about the size of the recent differences between the growth of M2 and spending. So, it is not prudent to put heavy weight on recent growth of M2 in the absence of other supporting evidence.

* Second, other measures of money do not show the same pattern as M2. The domestic monetary base, a more reliable measure of recent Federal Reserve actions, tells a different story. (The domestic monetary base is the sum of reserves that banks are required to hold and currency held by U.S. households and businesses.)

The chart on page D7 shows the relation between the growth in the domestic base and the growth in spending six quarters later. The relationship between the two is stronger now than in many previous periods. The slow growth of domestic base in 1987-89 was followed by slow growth of spending in 1989-90 and 1991. As usual, the first effect was on real production and employment. Eventually inflation fell to the 2% to 3% range that we now enjoy.

Growth of the domestic base rose beginning in 1989--and, with greater force, in 1990 and 1991. Successive reductions of interest rates by the Federal Reserve encouraged more rapid growth of the domestic base. Six quarters later, growth of spending began to rise.

No short-term forecasting relation consistently and reliably predicts changes in the economy. A rule of thumb for developed countries is that the average forecast error for total spending is between 30% and 50% of average growth. The best forecasters on average cannot tell whether there will be slow or fast growth a quarter or a year ahead.

The rule of thumb applies to all types of forecasts--whether based on hundreds of equations or on relation between the growth of money and spending. The good forecasting record of the domestic base may continue, or not, for a few more quarters or years.

More likely it will make errors similar to the errors made by short-term forecasting tools. These errors are often large. Indeed, the economy is much too complex and variable to forecast reliably. Policy-makers who adjust based on short-term forecasts probably do more harm than those who follow relatively stable, consistent policies aimed at the medium term.

Some will read the chart as suggesting that GDP growth will rise to about 7% in 1993. I read it as saying--contrary to the current critics--that the Fed eased money throughout the current recovery and continues to provide sufficient money to sustain growth.

The message for the future is that continued growth of the domestic base at recent rates will raise inflation, perhaps by 1994. Now is the time to stabilize the economy and prevent that increase. Prudence calls for about 2% less growth in the domestic monetary base than last year. This would be a slightly tighter monetary policy to lock in the gains against inflation brought about by the tight monetary policy from 1989 to 1991.

A Crystal Ball for Economic Growth?

In recent years, the domestic monetary base--a money supply measure consisting of bank reserves and the currency holdings of American businesses and households--has had an uncanny relationship to growth in the U.S. economy. As the chart shows, growth in the domestic base has been followed six quarters later by upswings in spending.