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June 12, 2007

Putting The Money Back In Monetary Policy?

The Wall Street Journal's Joellen Perry reports (page A8 in the print edition) on the latest debate within the European Central Bank:

With euro-zone interest rates near a six-year high, European Central Bank policy makers are clashing over the role of the swollen supply of money in pushing up prices.

That rare break in the bank's public facade of unity suggests policy makers are divided about how high to push interest rates in the 13-nation currency bloc, and it could rekindle a global debate on the merits of monitoring money supply...

Years of low interest rates have fueled a global liquidity glut that has inflation-wary central bankers world-wide paying attention to money-supply data. The ECB, as the only major central bank to give money-supply growth an official role in its decision-making, has led the charge. But other policy makers, including at the Bank of England and Sweden's Riksbank, have also cited strong money-supply growth as a reason for recent interest-rate rises.

Actually, Claus Vistesen was thinking about this last week, while I was in Frankfurt attending a joint conference on Monetary Strategy: Old issues and new challenges, jointly sponsored by the Deutsche Bundesbank and the Federal Reserve Bank of Cleveland.  The question of whether or not central bankers ought pay attention to money, and talk about it when they do, did come up. Gunter Beck and Volcker Wieland, both from the Goethe University Frankfurt (and the latter formerly of the Federal Reserve Board), offered up a theoretical argument for why the money-guys in the ECB might be on to something:

... we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output.

... We assume that the central bank checks regularly whether a filtered money growth series adjusted for output and velocity trends averages around the inflation target. If the central bank obtains successive signals of a sustained deviation of inflation from target it adjusts interest rates accordingly.

Our simulations indicate that persistent policy misperceptions regarding potential output induce a policy bias that translates into persistent deviations of inflation and money growth from target. In this case, our “two-pillar” policy rule may effectively overturn the policy bias. Cross-checking relies on filtered series of actual money and output growth without requiring estimates of potential output. Indirectly, however, it helps the central bank to learn the proper level of interest rates.

Some of the conference participants noted that there are lots of alternative (and established) statistical techniques for forecasting in the face of uncertainties about concepts such as potential output and the equilibrium real interest rate, but another of the conference papers -- from the Bundesbank's Martin Scharnagl and Christian Schumacher -- suggested that Beck and Wieland may just be on to something when they say the ECB money-guys may just be on to something:

This paper addresses the relative importance of monetary indicators for forecasting inflation in the euro area. The analysis is carried out in a Bayesian framework that explicitly considers model uncertainty with potentially many explanatory variables...

The empirical results show that money is an integral part of the forecasting model... The key finding of the paper is is that the majority of models include both monetary and non-monetary indicators.

To paraphrase, when it comes to short-run forecasts, the kitchen sink works best.  But the result that got my attention was Scharnagl and Schumacher's finding that, in their experiments, the trend in the money supply is the only factor that appears useful in forecasting inflation once you get out beyond about 6 quarters.

That may surprise you, but it probably shouldn't.  The Scharnagl and Schumacher study is on the technical side, but some years ago economists George McCandless and Warren Weber offered up some evidence which was pretty easy to grasp:




That's a graph of the relationship between average money growth (measured by M2) and average inflation for a large cross-section of countries, over the period from 1960 through 1990.  If you are an old hand on this topic, you probably remember that it was around 1990 that both the ECB and the Federal Reserve lost confidence in the money measures they were tracking.  The ECB responded by moving from a narrow measure of money to the very broad M3 concept.  The Federal Reserve responded by more-or-less abandoning monetary measures all together.

OK, let's take a look at the McCandless and Weber picture post-1990:




Hmm.  The Wall Street Journal article correctly notes that there is still a great deal of skepticism about the usefulness of monetary measures in formulating monetary policy:

The U.S. Federal Reserve is among the doubters. Fed Chairman Ben Bernanke said in November that a "heavy reliance" on money-supply data as a predictor of U.S. inflation was "unwise."

I don't think either the Beck-Wieland or Scharnagl-Schumacher work contradicts that skepticism about "heavy reliance." But maybe money deserves just a little more love on this side of the Atlantic than it currently gets?

June 12, 2007 in Europe, Federal Reserve and Monetary Policy | Permalink


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Francesco Giavazzi argues that monetary policy in Europe could be greatly improved with increased transparency at the European Central Bank: Sarkozy and the ECB: Right intuition, wrong target, by Francesco Giavazzi, VoxEU: During his electoral campaign... [Read More]

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And, maybe credit is more important than money, in the sense of the increasing ease with which economic actors can find credit which is less and less under the "control" of even the influence of the Fed.

For example, when vendors offer 0% interest out of desperation to get business, how effective is modest tweaking of the money supply?

Or, when "investment" flows into the domestic economy from outside the U.S. and the attraction is the rate of return of the investment irregardless of the level of "general" interest rates that the Fed might seek to influence.

Even banks have access to far more "capital" than the "money" they might borrow at the federal funds target interest rate, right?

And with securitization, banks don't even need much capital to sustain a "lending" business, right?

Mostly we simply accumulate "money" in money market mutual funds where it earns relatively high interest rates and effectively "grows" even more money (M2) much faster than the economy's need for capital in the form of "money", right?

We need to radically rethink our conceptions of "money" relative to "capital" and the needs of the economy for each.

-- Jack Krupansky

Posted by: Jack Krupansky | June 12, 2007 at 11:05 AM

MxV=PxQ. Problem is that central banks only look at P for goods and services, if they included P of assets then the mystery is solved. What makes this period different from others since 1960 is that Chinda 'beavers' have built a dam that prevents M flowing into price inflation the stream being diverted into asset inflation, which according to CB's isn't inflation at all. Heaven help when the dam gives way (protectionist/ USD depreciation/ excess foreign domestic demand).

Posted by: voltaire | June 12, 2007 at 05:44 PM

Am I reading those graphs correctly, in that the inflation axis goes from 0 to 100% CPI inflation (per year)?

If so, it seems completely irrelevant to modern concerns about inflation in the 1-4% range.

It would be interesting to expand the relevant portion of the graph, say from 0-5% inflation, and see how strong the correlation is in that range.

Posted by: ErikR | June 13, 2007 at 11:12 AM

Thanks for the reference! Here is a relevant quote from the paper Jef found:

"Our second finding is that this strong link between inflation and money
growth is almost wholly due to the presence of high-inflation or hyperinflation
countries in the sample. The relation between inflation and
money growth for low-inflation countries (on average less than 10% per
year over 30 years) is weak, if not absent."

Posted by: ErikR | June 17, 2007 at 12:49 PM

First, there is no ambiguity in forecasts. In contradistinction to Bernanke, forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The FOMC, etc., has learned their catechisms;
Friedman became famous using only half the equation, leaving his believers with the labor of Sisyphus.
The lags for monetary flows (MVt), i.e., real GDP and the deflator are exact, unvarying, constant. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).
Not surprisingly, adjusted member commercial bank free legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –-- their lengths are identical. The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly. Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets (housing being most notable), it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The "administered" prices would not be the "asked" prices were they not “validated” by (MVt).

Posted by: flow5 | July 29, 2007 at 01:37 PM

There is no one alive that understands money & central banking.

No accolades here:

Milton was loath to grant central bankers much discretion in formulating and executing monetary policy.

(1) Friedman couldn't define/kept changing the definition of the "money" supply to target. Money is the measure of liquidity, the "yardstick" by which the liquidity of all other assets is measured.
(2) the "monetary base/high powered money” [sic] is not a base for the expansion of the money supply.
(3) the "multiplier" is derived from "money" divided by member commercial bank legal reserves, not the monetary base..
(4) aggregate demand is measured by monetary flows (MVt), i.e., income velocity is a contrived figure (WSJ, Sept. 1, 1983)
(5) the rates of change used by the Fed are specious (always at an annualized rate having no nexus with economic lags; Friedman pontificated variable lags; economic lags are unvarying)
(6)Friedman (1959) has long advocated the payment of interest on reserves at a market rate in order to eliminate the distortions associated with the tax on reserves.

A. Friedman didn't know the difference between the supply of money and the supply of loan funds.
B. didn't know the difference between means-of-payment money and liquid assets.
C. didn't know the difference between financial intermediaries and money creating institutions.
D. didn't recognize aggregate monetary demand is measured by the monetary flows (MVt) not nominal GDP.
And the technicians at the Fed:
E. don’t recognize that interest rates are the price of loan-funds, not the price of money
F. don't recognize that the price of money is represented by the price (CPI) level.
G. don't realize that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds.
That's some legacy.

Posted by: flow5 | July 29, 2007 at 01:54 PM

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