OT Fed kills a key inflation gauge

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Fed kills a key inflation gauge

The Fed wants you to think it's fighting inflation. So why did it kill an
important measure of the money-supply boom that feeds rising prices?

By Jim Jubak

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 M3
No, 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 inflation
For 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:

1. Money supply isn't a good indicator of future inflation.

2. 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.

3. 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.

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.

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.


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