The Fed and Its Critics Should Let Money Be Their Guide

Last week’s Federal Open Market Committee (FOMC) left interest rates unchanged.  Two groups of observers are likely to intensify their criticisms of the Fed as a result.  Each group, however, has a very different argument for change: One views increasing rates as a monetary contraction whereas the other views it as an expansionary action.  To resolve these ambiguities, and more reliably gauge the true stance of monetary policy, the Fed and its critics need to look past the behavior of interest rates and make better use of information provided by measures of the money supply.

One recurring argument, often invoked by dissenting members of the FOMC as well as outside observers, states that interest rates need to be increased now as a pre-emptive action against future inflation rising above the Fed’s long-run target of two percent.  Under Keynesian assumptions that prices and wages are slow to adjust, these policy-induced increases in nominal interest rates also lead to higher real interest rates.  Higher real rates discourage spending, prevent the economy from “overheating,” and thereby relieve aggregate demand pressures that would otherwise lead to higher inflation.

In contrast to this traditional Keynesian reasoning, a more recently developed school of thought advocates in favor of higher nominal interest rates because, in this alternative view, higher rates may actually translate into expansionary monetary policy.  This neo-Fisherian view takes its name from Irving Fisher’s theory of interest, which expresses the nominal interest rate i = r + p^e as the sum of the real interest rate r and the expected rate of inflation p^e.  The Fisher equation has long been used to explain how increases in expected inflation lead to high nominal interest rates.  Neo-Fisherian economists, however, have constructed interesting examples that reverse the direction of causality, so that higher nominal interest rates work to increase both expected and actual inflation.

Although novel in their details, neo-Fisherian theories reinforce older positions, held by Milton Friedman and other monetarist economists, that higher nominal interest rates can signal that monetary policy is too accommodative just as often as they show that policy is too tight.  It was, in fact, precisely this ambiguity – which has reclaimed center stage in recent debates – that led Friedman to prefer the monetary aggregates as indicators of the stance of monetary policy.

Quantity theorists like Friedman organize their analyses around the quantity equation, MV = PY, where M is the money supply, V the velocity of money, P the aggregate price level, and Y real GDP.  Thus, the quantity equation describes how policy-induced changes in the money supply translate directly into changes in nominal income PY.  Depending on how quickly prices and wages adjust, accelerating nominal income growth, driven by monetary expansion, may be accompanied by faster real GDP growth in the short run.  In the long run, however, changes in money get reflected as proportional changes in prices.  The quantity theory thereby links the behavior of inflation not to interest rates but to growth in the money supply.

Skeptics of quantity-theoretic reasoning often assert that financial innovations and other changes in the economy make the velocity of money unstable and hard to predict.  Our own recent research shows that, to the contrary, movements in V are sufficiently small and smooth to allow the Fed to stabilize nominal income through policies directed at targeting money instead of interest rates.  For our purposes here, however, we can accept this point of objection if only for the sake of argument.  It is true that fluctuations in V, if and when they occur, mean that policies of constant money growth no longer lead to steady growth in nominal GDP.  Yet, so long as policy actions taken to adjust the rate of money growth are not, by themselves, additional sources of instability in velocity, the quantity theory still implies that the most reliable way for a central bank to decrease the rate of inflation is to take actions that decrease the rate of money growth and, conversely, that the best way to increase inflation is to increase money growth.

An enduring strength of the quantity theory, therefore, is that its implications remain robust to changing views of the forces affecting interest rates.  Both the FOMC and its critics could take advantage of this and usefully recast their arguments in terms of their prescriptions for money instead of interest rates.  Doing so would make clear that if the Fed is worried about inflation, it should act to decrease the rate of money growth; and if the Fed is worried about deflation, it should move to increase money growth.  Understood and explained through quantity-theoretic reasoning, there can be no doubt that control of long-run inflation is a goal that the Fed can achieve.

Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee. 

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