Fed Policy and the Money Supply

It almost goes without saying that the Fed's primary job is to ensure a stable currency.  Most of the time, that means preventing inflation (unanticipated inflation, to be more precise), but sometimes it means preventing deflation. 

Currently, the Fed's lever of choice for accomplishing that goal is the target interest rate banks charge each other to meet the Fed's reserve requirements.  A target of 5.25% has been the policy for more than a year, but it might change tomorrow (9/18) when the Fed meets again. 

When I sample internet forum discussions about money and the Fed, the "money supply" is mentioned frequently, because many people still equate a growing money supply to growing inflation.  What is almost never mentioned, however, is "money demand"—which is curious, because when the supply of money grows in tandem with the demand for money to support the real economy, inflation is unaffected.  Not only that, but the demand for money is what the Fed is strongly influencing when it targets the interest rate to implement monetary policy.  Supply and demand together are just as important for monetary analysis as for goods and services. 

A fact of life is that targeting the interest rate means giving up control of the money supply.  Conversely, if the policy were to target the money supply, it would mean giving up control of the interest rate (...and high interest rates of the early '80s, when the Fed was targeting the money supply, are a good example).  Here are two simple illustrations showing what the Fed can control (red line) and cannot control (yellow circle), as the demand for money grows steadily, as it must when the real economy grows steadily. 

So today, with the Fed targeting the interest rate, the level of the money supply is an outcome, not a control variable.  It's a result of the demand for money and the price of money (i.e., the interest rate).  The Fed's job isn't easy in any case; measuring the inflation rate and growth rate accurately is difficult, and measuring the money supply is even more difficult if not impossible.  Bottom line: the Fed's ability to gauge true inflation rates and real growth rates are much more to the point than the money supply level. 

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For further reading, here's a concise summary, Formulating Monetary Policy, by William F. Hummel.

Comments

[Bob]

Time again for a rant on inflation and the Fed.

Clearly we are in a period in which global supply and demand is more pronounced. Therefore, the Fed should take this into account and I'll be darned if I see anything from them that they are. Do they really have the tools to estimate supply and demand on a global basis?

If productivity is to be watched closely yet the economy is less dependent on manufacturing but goods producing productivity is the key measurement, we need measures of productivity for non-goods producing industries. What are they and is the Fed dialed into them?

Lastly, my favorite rant. The Fed gets all worried about the employment rate because workers will demand more compensation and without a resulting increase in productivity or lower company profits, prices will increase. Okay, I get that. But, how many folks out there are getting a cost of living adjustment on top of any
merit increase?

It's a new world and I don't think the Fed is in tune with it. I don't see that as a good thing.

[rufus]

The idea of having a group of pointy-headed old men setting interest rates in a "free market" economy is an abomination.

Especially a group of pointy-headed old dorks who never got past "Keynes," and "Rationing."

They're a bad joke. The FF Target is a full point above the Nominal growth rate of GDP. They move aggressively, soon, or we will go into recession (at which time they will HAVE TO move.

Dolts. Bring on Uncle Milty's computer, set it for five basis points below the three month T bill, and call it a day.

[Mike Sproul]

Money demand is seldom mentioned?? Not in the econ textbooks I've seen. Want a theory that is NEVER mentioned? Try the real bills doctrine. The real bills doctrine says that if the Fed increases the money supply by 10%, while at the same time increasing its assets by 10%, then the new money is adequately backed and there will be no inflation. So the way to achieve a stable currency is for the Fed to always acquire a dollar's worth of bonds every time it issues a new dollar. Money supply and money demand have nothing to do with it.

Please google "real bills doctrine" before posting any knee-jerk reactions to the above.

[Mike Sproul]

Money demand is seldom mentioned?? Not in the econ textbooks I've seen. Want a theory that is NEVER mentioned? Try the real bills doctrine. The real bills doctrine says that if the Fed increases the money supply by 10%, while at the same time increasing its assets by 10%, then the new money is adequately backed and there will be no inflation. So the way to achieve a stable currency is for the Fed to always acquire a dollar's worth of bonds every time it issues a new dollar. Money supply and money demand have nothing to do with it.

Please google "real bills doctrine" before posting any knee-jerk reactions to the above.

[Steve]

Mike:
It's seldom mentioned in the press, and therefore in internet forums. I should have qualified that better.

Also: Buying assets from the public (almost always T-securities) is *precisely* how the Fed creates new base money -- which implies that the so-called real bills doctrine boils down to "inflation is impossible." Sorry, I don't buy that. If the Fed creates too much base money, it is inflationary; if it creates too little, it is deflationary. The Fed's challenge is to keep future inflation in check while providing enough money to support (future) real growth.

[Mike H]

Steve,

Are you at all worried that the fed move today will bail irresponsible banks and borrowers out in the housing market too much? That's my main concern. I know they were practically forced to drop rates at least 25bp, but I wish they could have kept the rate where it was and finally teach people a lesson. Guess that's too much to ask of any part of the government though.

[Mike H]

Steve,

Are you at all worried that the fed move today will bail irresponsible banks and borrowers out in the housing market too much? That's my main concern. I know they were practically forced to drop rates at least 25bp, but I wish they could have kept the rate where it was and finally teach people a lesson. Guess that's too much to ask of any part of the government though.

[Steve]

Mike:
The irresponsible banks (and there are plenty) just might not get the punishment they deserve, but it's not as much a result of the Fed's action as it is the lack of transparency into the bundled paper that the original banks sold to subsequent buyers, who sold it again, etc. Caveat emptor, yes -- but when it threatens the liquidity of the whole system, something's gotta give. Although the original culprits may survive (undeservedly), this is one of those lessons the market and regulators had to learn the hard way. Look for new regulations to emerge because of this; here's a good article discussing that point:
http://tinyurl.com/2twwt2

[Zephyr]

Teaching the "culprits" a lesson would come at great expense to the rest of us. The Great Depression came of the this kind of thinking. We don't need any more lessons taught by monetary and economic constriction.

I am glad the fed backed off from the artificially high 5.25% target rate. Perhaps ther high rate was needed (for a while) to counteract the artificially low 1.00% rate that Greenspan gave us. One overreaction to counteract a previous overreaction.

I would like to see a less interventionist and more market tolerant Fed policy. This would mean leaving the Fed Funds target ratte in a position that is normal relative to the yield curvre. At 4.75% it is still high relative to the rest of the yield curve.

[Mike Sproul]

Steve:

"so-called real bills doctrine boils down to "inflation is impossible." Sorry, I don't buy that. If the Fed creates too much base money, it is inflationary; if it creates too little, it is deflationary."

The real bills doctrine doesn't say inflation is impossible. It says that inflation results from a loss of backing, not from an increase in the quantity of money. If the Fed issued $100 in exchange for $100 worth of bonds, then the real bills view is that there will be no inflation. But if those bonds are only worth $99, then the Fed has 1% less backing than it should have, and inflation will result.

[Aaron]

I think that some of the sub-prime will still be in trouble because of the teaser rates and their customer base. Its at least a shot across the bow. (The rate cut will help those with ARMs though.)

So, the banks have a breather to figure out who wons what risk exactly. Somehow I doubt that tomorrow they start up the sub-prime lending party again.

[Jim Bradley]

Problem is there's no "demand for money" that's not mixed with "demand for assets" ... so in an asset bubble, it is usually the "rising demand for money" that allows the low inflation asset bubble to develop.

Bottom line, creating money is a real hazard because it alters the structure of production and if it turns out that structure is inflationary (by having too many projects that are resource intensive) then it takes a liquidation of many businesses in industries that are intense users of capital to bring inflation into line. At present, we have "structural inflation" in the U.S. economy and it is going to take a more and more serious correction (now that Ben is cutting rates and not allowing the pain now) down the line.