WASHINGTON -- Federal Reserve officials are struggling to explain why the money supply has remained anemic despite the Fed's repeated trims in short-term interest rates, board Chairman Alan Greenspan said yesterday.
Testifying before the House Banking Committee's domestic monetary policy subcommittee, Mr. Greenspan conceded that Fed officials have been "extremely puzzled" by changing relationships between the money supply, the economy, and interest rates.
Historically, there is a correlation between growth in the money supply and nominal gross domestic product, and cuts in short-term interest rates typically help boost the money supply. However, even though the Fed has trimmed rates repeatedly since 1989, the money supply has fallen below the central bank's target ranges, and the economy has soured.
Mr. Greenspan said the normal relationship between money supply and economic growth broke down "a couple of years ago," forcing Fed officials to come up with new explanations for what is going on. This involves an effort to understand what levels for the federal funds rate, now at 3.25%, are appropriate, he said.
Mr. Greenspan reasserted the Fed's view that part of the explanation for the slow growth in the money supply can be found in the flight by investors from low-yielding bank deposits to bond funds and other assets. "A lot of the money supply has moved out of the money supply into other instruments," he said.
Still, he said, "we cannot fully argue that money in the form of M2 no longer matters. We still believe it has significant forecasting and analytical properties." And, said Mr. Greenspan, "we are not close to recommending a change in the definition [of M2]. We do not think that is what the problem is."
But Mr. Greenspan also said that Fed officials are "developing information" on the money supply that they plan to make available to congressional staff members "at some point." He did not elaborate.
Given the uncertainties over the relationship between the money supply and the economy, members of the Federal Open Market Committee decided to leave the money supply targets unchanged for next year, Mr. Greenspan said. The targets call for M2 growth between 2.5% and 6.5% and for M3 growth of 1% to 5%.
But over the long term, Fed policymakers are committed to further trimming of the money supply targets in line with their commitment to achieving price stability, Mr. Greenspan said.
House subcommittee members generally gave the Fed chairman a much more cordial hearing than the Senate Banking Committee did on Tuesday, when he delivered the Fed's Humphrey-Hawkins report on monetary policy. Rep. Stephen Neal, D-N.C., said the "constant, misguided carping" for the Fed to ease rates threatened to stir inflation fears in the market and raise long-term rates.
Rep. Toby Roth, R-Wis., the panel's ranking minority member, said the budget deficit is the chief problem for the economy, not inflation or interest rates.