Jim Jubak

Jubak's Journal3/31/2006 12:00 AM ET

Fed kills a key inflation gauge

Continued from page 1

You'd especially think that would be the case because the Federal Reserve has so publicly raised the possibility that the explanation for the current unusual combination of high economic growth and low interest rates is a global excess of capital. If that might be so, wouldn't it be useful to develop a standard monetary measure to track it?

But instead of expanding the definition of money, the Federal Reserve is contracting it.

I'm not generally a believer in Federal Reserve conspiracy theories. But in this instance, the conspiracy theorists make an intriguing point. The Federal Reserve decided to kill off M3, they argue, because it is the measure that shows the fastest growth in the money supply. For the 12-month period that ended in February 2006, for example, M3 grew at annual rate of 8%, but M1 grew by just 0.4% and M2 by 4.7%. Certainly, getting rid of M3 makes it harder to argue that the short-term inflation fighters at the Federal Reserve are actually very soft on long-term inflation. Maybe so soft that you could say they love long-term inflation.

Fuel for conspiracy theorists

The Federal Reserve conspiracy theorists go on to argue that this is exactly the kind of monetary policy you'd expect from the world's greatest debtor nation. Use your credentials as a short-term inflation fighter to convince global savers it's safe to buy U.S. dollars and U.S. debt, while at the same time supporting the long-term inflation that will cut the future value of that debt and thus let the U.S. pay back its current debt in less-valuable future dollars.

Of course, I'd never want to go so far as to put something like that in print. It's just too outlandish to believe.

So instead, let me offer up a more concrete fear. Although the Federal Reserve may be correct when it argues that there isn't a tight connection between inflation and growth in the money supply over the short-run, the data does argue, convincingly in my opinion, for a connection in the long run. In the long run, countries with faster-growing money supplies experience higher inflation.

And even worse, if the money supply grows fast enough, it provides the liquidity required for the runaway growth of asset bubbles, like the stock market in 2000. And, some would argue, like the U.S. real-estate or credit markets now.

Certainly the European Central Bank believes this. Its inflation policies are based on using a mix of economic data -- something like the Fed's mix of producer prices, job growth, confidence and wage rates -- to judge short-term inflation. This data feeds into the bank's target for price inflation of "below but close to 2%."

But the European Central Bank also looks at the growth of the money supply, its version of M3, when it sets interest rates. M3 growth accelerated to an 8% annual rate in February 2006, up from 7.6% in January, and the fastest rate since September 2005. That's one reason that European financial markets are so convinced that the European Central Bank will raise short-term interest rates again when it meets in May -- to 2.75% -- and why the futures markets have priced in hikes that would take short-term rates to 3.25% by the end of 2006.

The difference in the two banks' approaches has implications well beyond inflation, however. The European Central Bank is willing to sacrifice some short-term growth in order to head off the growth of asset bubbles and the damage caused when they deflate. The U.S. Federal Reserve has repeatedly declared its belief that, given the huge uncertainties in economic data, it is too risky to try to head off bubbles and it's better to clean up the mess afterward. Certainly that was the Fed's position in 1999: as equity prices rose at what Fed chairman Greenspan called an irrational pace, the bank refused to cut off credit to traders by raising margin requirements.

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So if you want to fully understand the Federal Reserve -- and where this most-powerful U.S. economic institution is taking the national and global economy -- don't just look at the headlines touting the Fed as inflation fighter. Higher interest rates are half the story. And the near-term half, at that.

Because, even as the Federal Reserve is raising the cost of money for consumers and home buyers, it's keeping the money supply spigots wide open.

In the long run, that's likely to be more important to you than the next quarter-point hike in interest rates.

New developments on past columns

The trade deficit's deep bite: It's official. China now holds the largest foreign exchange reserves in the world. At the end of February, thanks to the country's most recent monthly trade surplus and continued inflows of foreign investment, China's reserves reached $854 billion. That inched China ahead of Japan, which held reserves of $850 billion. Zhou Xiaochuan, governor of the People's Bank of China, defended China's current policies, saying that his country was on the road to a basic balance in international trade but that it would take China two to three years to reach that balance. Besides, he noted, on a per capita measure, China's foreign reserves are quite modest. China's population was about 1.3 billion as of July 2005.

Editor's Note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. For suggestions to help navigate the treacherous interest-rate environment see Jim's portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.

E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.

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