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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?
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