Political meddling in the affairs of central banks is unfortunate, though surely not unknown. It weakens the credibility of the monetary authorities, raises inflation expectations, and builds an inflation premium into long-term interest rates. This is why countries around the world, from Mexico to France, are making their central banks independent.
This lesson has not yet been fully learned by Congress, whose key members have recently criticized the Federal Reserve for its conduct of monetary policy (see The New York Times, June 13, 1993). The debate is not inconsequential, since Fed Chairman Alan Greenspan is to appear before Congress to present the Fed's midyear Humphrey-Hawkins testimony in late July.
Congress is wrong in contending that the Fed's policy of tight money continues to imperil the U.S. economy. Actually, the Fed is being too loose at present, not too tight. However, the Fed's failure to replace its abandoned M2 target with any new policy indicator does serve to confuse the debate. It is worth examining this discussion point by point.
1) "For a year and a half, and especially over the last three months, the Federal Reserve has engineered money growth [M12] far below the target ranges (2% to 6%)."
The key issue to understand here is that the Fed cannot control M2 growth. This is because M2 is now a private-sector portfolio choice, having little to do with the Fed's reserve creation policies.
With money market rates at 30-year lows, the private sector has gone in search of higher-yielding investments. There has been a massive exodus of funds from the banking system, M2, into the capital markets. This has reduced the liability side of the banks' balance sheets. In the first four months of this year, bond funds grew by $40 billion and stock funds by $42 billion, while M2 declined by $26 billion. Why should policy makers fret over a reallocation of private portfolios?
The capital markets are also increasingly financing activities that traditionally have been financed by the banking system. For example, mortgage lending is increasingly financed by the capital markets in the form of mortgage-backed securities. Banks originate loans and then sell them so that they are no longer on the banking system's balance sheet. Long-term corporate debt and initial public offering issuance is also financed by the capital markets.
Adjusting M2 for inflows into bond and stock funds presents an entirely different picture of the money supply. Whereas over the 12 months to April, M2 grew by 0.3%, M2 plus bond funds grew by 3%, and M2 plus bond and stock funds grew by 5 1/4%.
Moreover, the Fed has eliminated all reserve requirements on small time deposits. Hence the Fed has no direct control on the interest-bearing component of M2 - so called non-M1l M2 - which accounts for more than 70% of M2. in fact, statistical work by Darnel Thornton of the St. Louis Fed has shown that the effects of reserve policy on non-M1 M2 are "statistically insignificant."
2) "Raising interest rate targets would mean slowing the money supply even more. And that would severely damage the economy."
Actually, raising interest rates would probably boost M2. Since M2 is the result of private-sector portfolio choice, higher short-term rates would make bank deposits attractive relative to bonds and stocks. This would stem inflows of new savings and existing bank deposits into, bond and stock funds. M2 growth would begin to accelerate. This is what was happening in Germany last year on a larger scale. The Bundesbank kept short-term interest rates so tight that the yield curve was inverted, making bank deposits more attractive in yield terms than bunds, and German M3 persistently grew above its target range.
In any event, M2's relationship with the economy has completely broken down, as Alan Greenspan admitted at his recent New York Economic Club speech. Over the last two years, M2 has grown at an annualized rate of 1.6%, while nominal gross domestic product has risen at a 4.9% rate. Thus, the velocity of M2 has risen at a 2.5% annualized rate. Those who think that M2 has a stable and predictable relationship with the economy cannot explain this because M2 velocity historically has fallen as interest rates have declined. Rising M2 velocity and declining interest rates over the last two years show that M2 is not a driving force of the economy.
Furthermore, economic activity would be accelerated in the short run by a signal from the Fed that interest rates have bottomed. Many people have deferred house purchases, investments, and other spending in the hope of catching financing rates at the bottom. A signal that the four-year-long move to lower rates is over would generate a burst of spending. This spending would raise the demand for bank loans and hence boost M2 growth.
3) "The Federal Reserve's campaign of lightening the money supply now is similar to its policies in the Great Depression of the 1930s."
This comparison is absurd. Between October 1929 and February 1932, the supply of bank reserves contracted by 23%. Over the last two years, the supply of reserves has grown by over 30%. In fact the Fed's creation of high-powered liquidity is accelerating as the Fed attempts to maintain short-term rates below their natural rate of somewhere around 5%.
By any measure of liquidity the Fed directly controls, the Fed is being too loose at present. Reserve bank credit, for example, has grown by $38 billion over the last year, and is up sharply from $25 billion just four months ago. Total bank assets are rising by $70 billion ahead of last year. Moreover, it takes time for this liquidity creation to materialize in broader measures of money. But this may be beginning to happen - M2 is accelerating. Over the last 13 weeks M2 has grown at a 4.1% pace, and over the last four weeks M2 growth has run at a 10.9% rate. This faster growth is bringing M2 back into the Fed's target range. Slow M2 growth may be yesterday's news.
4)" Sound money and sound growth are not inconsistent, incompatible, or even impossible goals. "
At last, something we can agree on. But sound money does not mean holding down short-term interest rates at 3%, accelerating the growth of bank reserves, and boosting the price of gold above $400 an ounce. Such a policy would push the inflation rate to 5% or even higher. That would boost the effective tax rate on real capital gains to 75% or 82%, if the Senate's 10% surcharge on capital gains passes). Long-bond yields would rise to 9%, killing business investment and housing activity.
But the Fed's abandonment of M2 without replacing it with another target does serve to confuse the issue. It leaves investors and policymakers confused over the Fed's true intentions and raises uncertainty over the future outlook for inflation. Hopefully, Greenspan will provide a new target in his forthcoming congressional hearings. Otherwise, rising uncertainty premiums may creep into bond yields.
Sound money and sound growth are in fact quite achievable if the Fed adopts the right targets. Why not link the value of money to assets that are beyond the control of governments, such as gold or the Japanese yen? These are reliable. noninflationary benchmarks that would help policymakers to balance the quantity of money supplied with the quantity demanded. The quality of money would rise permanently, followed by a permanent decline in long-run inflation expectations and long-term bond yields.
Add a dose of new tax incentives to lower real capital costs and raise real investment returns, along with new budget enforcement rules to contain domestic budget spending, and then the twin goals of sound money and sound growth would be achievable. Miraculously. John Ryding is senior economist and vice president at Bear Stearns & Co. He has also served as a senior economist at the Federal Reserve Bank of New York, and as an economist with the Bank of England.
