The U.S. Federal Reserve made big news at the end of March. And almost nobody noticed. Here's the headline you didn't see:
- Fed kills M3, decides money supply doesn't count: Move raises risk of higher long-term inflation and new asset bubble
I'm obviously not talking about the March 28 decision to raise short-term interest rates one more time to 4.75%. That got headlines all right, and most of them portrayed the Federal Reserve as a tough fighter against inflation.
The March 28 interest-rate hike wasn't exactly unimportant. Stocks and bonds both took a hit that day because the language accompanying the Fed's 15th rate hike since June 2004 proved that those who had bet on "one more and done" were clearly wrong. The Federal Open Market Committee is now very likely -- an 88% chance, according to the futures market -- to raise rates again at its next meeting on May 10. The odds on a further hike at the end of June have started to climb as well. Higher interest rates in the future will put downward pressure on the prices of stocks and bonds.
The death of M3No, the underreported story that, in my opinion, deserved headline treatment and didn't get it was the end of M3, on March 23. As the Federal Reserve had promised last November, the U.S. central bank will no longer collect or publish this most-inclusive measure of the growth of the U.S. money supply, although it will continue to publish narrower measures such as M1 and M2.
Why should you mourn the death of a statistical measure? Because inflation (unless you're a strict monetarist) has two causes:
- Cause 1: Prices go up when demand exceeds supply. This is the kind of inflation the Federal Reserve under Alan Greenspan and Ben Bernanke has targeted and is working to control with interest-rate increases that are intended to reduce demand in the economy to non-inflationary levels.
- Cause 2: Growth in the money supply produces inflation as the price of money itself fluctuates with changes in the supply and demand for money.
This monetarist view of the link between growth in the money supply and growth in inflation was once part of mainstream thinking at the U.S. Federal Reserve. The great monetarist economist Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon." That view was echoed in policy at the U.S. Fed when then-chairman Paul Volcker starved the inflation of the late 1970s by tightening the money supply.
But the Fed -- under Greenspan, and so far under Bernanke -- has behaved as if money supply growth didn't matter and as if price inflation were all that mattered. Even as they have raised interest rates in an effort to slow the economy and reduce demand, they've continued to let money supply grow at close to double-digit rates. M3, the most inclusive measure of the money supply, grew at a seasonally adjusted annual rate of 8.7% in the three months from November 2005 to February 2006. That's faster than the annual rate -- 8% -- for the 12-month period beginning in February 2005.
In other words, as the Federal Reserve was fighting inflation by raising interest rates to 4.75%, from 4% in November 2005, it was letting the money supply grow by an inflationary 8.7%. While it was fighting inflation by raising interest rates to 4.75%, from 2.5% in February 2005, it was letting the money supply grow by 8%.
Origins of inflationFor me, something is wrong with this inflation picture.
Not according to the U.S. Federal Reserve, of course. The Federal Reserve's official policy, as articulated by officials such as Don Kohn, a governor of the Fed, at a recent conference sponsored by the European Central Bank, is that:
- Money supply isn't a good indicator of future inflation.
- While rapid growth in the money supply may be connected to asset bubbles such as the 2000 stock-market collapse, the connection is too full of uncertainties to manage.
- Measuring the money supply is too darn expensive and difficult anyway.
I'd certainly agree that a measure of the money supply like M3, which combines M1 (currency in circulation, commercial bank demand deposits, automatic transfers from savings accounts, savings-bank demand deposits and travelers checks) with M2 (overnight repurchase agreements between banks, overnight eurodollars, savings accounts, CDs under $100,000 and money market shares) is woefully inadequate in an age when securitizations of mortgages and other debt instruments, the debits and credits of the international carry trade in currencies and the vast derivative markets can add hundreds of billions of global liquidity in a matter of hours.
Because it's so hard to say exactly what money is today, a measure like M3 does seem antiquated.
But that makes it even odder, in my opinion, that the Federal Reserve would decide to kill off M3, the most inclusive of current money-supply measures, yet keep collecting the data for narrower definitions of money such as M1 and M2.
Rather than killing off M3, you'd think the Federal Reserve would be spending money to develop and publish data for an M4 and maybe an M5 to track the ebbs and flows of an even-more-expansive definition of money that includes some of the new forms of money that have been manufactured on Wall Street and in other global banking sectors.