Chair Yellen’s Worries Are Warranted
Last week’s speech by Federal Reserve Chair Janet Yellen reinforced the strong note of caution evident in the most recent policy statement and economic projections issued by the Federal Open Market Committee (FOMC). Chair Yellen described how domestic “headwinds” continue to restrain the US economy and how “global developments,” particularly in China, threaten to derail its recovery from the financial crisis and recession of 2007-2009.
Chair Yellen may be right, but her comments left many listeners wondering whether the Fed should be paying attention to so many variables, including international stock prices, that lie clearly beyond its influence or control. Measures of money growth reflect more accurately the stance of Fed policy and have been trending downwards since 2013. This monetary tightening, by itself, serves warning that further interest rates increases could be excessive.
When the FOMC first raised its federal funds rate target last December, it seemed likely that interest rates would continue to rise throughout all of 2016. In light of their concerns, however, Chair Yellen and other Committee members appear to have postponed any consideration of further rate hikes until June, at the earliest. Financial market participants, some of whom anticipated that the FOMC would tighten as many as four times this year, now expect no more than two additional rate hikes before the end of 2016.
As always, it is important to acknowledge that these policy decisions are made under conditions of uncertainty. Economic growth might re-accelerate this spring and summer, and inflation could move closer to the FOMC’s two percent long-run target. In that case, the extreme caution that the FOMC has shown will, in retrospect, appear unwarranted. On the other hand, the US economy might continue to sputter ahead in fits and starts while inflation remains well below target. In that case, the Fed will deserve credit for not rushing to tighten policy by too much, too soon.
Especially in times of uncertainty it can be worth examining a variety of indicators to gauge the stance of monetary policy and assess the effects it is having on the economy. Traditionally, Federal Reserve officials see themselves as conducting monetary policy by managing interest rates, with low interest rates signaling that policy is accommodative and higher rates that policy is more restrictive. In today’s environment, however, it is far from clear why interest rates, even on longer-term bonds, remain so low. Possibly, it is because Fed policy is excessively accommodative. But maybe low interest rates reflect bond traders’ expectations that inflation will remain below target for quite some time, indicating that monetary policy, far from being accommodative, is excessively restrictive instead.
Milton Friedman and other monetarist economists pointed out that, particularly when long-term inflationary expectations may not be well-anchored, money growth rates can provide more reliable information than interest rates regarding whether policy is too easy or too tight. Surprisingly, though, almost no one inside or outside the Fed monitors measures of money anymore.
The graph below plots the growth rate of the Divisia M2 monetary aggregate, constructed at the Center for Financial Stability. It shows how, when judged by its implications for money growth instead of interest rates, monetary policy tightened relentlessly in the years leading up to the financial crisis of 2007 and declined sharply, as well, when the FOMC ended its first round of quantitative easing – prematurely, it seems – in 2010. M2 has been growing at an annual rate of about 6 percent for the past several years: this is a healthy pace, which ought to support a continuing recovery and gradual return of inflation to the two percent target.
On the other hand, the graph also shows that for some time now, money growth has been trending downward, falling from 7.5 percent in the first quarter of 2013 to 5.8 percent in the final quarter of 2015. From a monetarist perspective, these data indicate that policy began to tighten well before the FOMC raised the federal funds rate last December. Against this backdrop of decelerating money growth, it makes sense to exercise caution, as Chair Yellen and her colleagues suggest, before raising the funds rate target any further.
But by ignoring signals sent by the monetary aggregates, the FOMC is missing a chance to clarify and defend more effectively its policy decisions. And by referring, instead, to a shifting range of other variables – unemployment, oil prices, foreign exchange rates, long-term bond yields, and even stock prices – to justify its actions, the FOMC seems only to have added to popular confusion about its strategies and objectives. Because low inflation remains the Fed’s biggest concern and because “inflation is always and everywhere a monetary phenomenon,” it would make more sense for the FOMC to keep its focus, and the public’s attention, on the variables that it can reliably control: money growth and inflation.