My commentary on monetary policy this past June (“Current Fed Policy Is Inflationary”) struck a chord with critics, many of whom informed me that inflation was purely too much money chasing too few goods and that rising interest rates had no effect on inflation. For casual readers, the root definition of “money” is the monetary base, which is composed of currency in circulation and member bank reserves. The monetary base is considered the source for the creation of other forms of money. For example, the measure known as M1 is the monetary base plus demand deposits.
As I review these reader comments today, I guess they intended me to conclude that excess monetary-base growth will produce inflation. In the old days, the analogy was that the head of the Federal Reserve flew around in a helicopter and dropped dollars on the economy. In other words, when the Fed printed more money than the economy could absorb, inflation was the outcome. The problem with this equation is that there is no mention of the demand for money. When there is excess monetary-base growth — i.e. the printing of “too much” money and an increase in bank reserves — my critics conclude that the logical answer is more inflation.
In previous articles I have argued that the current Fed monetary policy of targeting a precise fed funds rate to temper inflation requires that the Fed buy or sell the exact amount of government securities to influence the reserve levels producing the desired fed funds rate. If the Fed increases or decreases bank reserves by more or less than the precise amount, the result would be wide swings in the funds rate. Stability in the funds rate in recent years indicates that the Fed is adhering to an interest-rate targeting strategy. However, if the Fed attempted to switch to the control of money growth (a quantity rule), the fed funds rate would have to be ignored, and the determination of interest rates would be left to the New York Fed trading desk, as was the case prior to 1981. If the Fed attempted to balloon the money supply, the fed funds rate would quickly drop to zero as banks, flush with reserves (non-interest-bearing financial assets), would pay little or nothing for the reserves they didn’t need.
Japan, the world’s second-largest industrial economy, adopted such a policy in March 2001. Attempting to stimulate its economy, the Bank of Japan (BOJ) adopted quantitative easing. The manifestation of this policy was a jump in the Japanese monetary base and a collapse in interest rates, with short-term interest rates moving to virtually zero (Figures 1 and 4).
Figure 1 shows the growth rate in the monetary base moving as high as 28 percent in 2002. This is a rapid rate of growth, especially for an economy with below-average growth (Figure 2).
Yet, inflation — as measured by the ubiquitous consumer price index — actually fell between 2001 and most of 2004. In other words, Japan experienced continuous deflation during a time of excess monetary-base growth ( Figure 3).
Interest rates, especially long-term interest rates, have been a traditional indicator of inflationary expectations. Using the 10-year government bond yield as depicted in Figure 4, interest rates in Japan have risen only 0.5 to 1.5 percent following a more than 20 percent increase in the monetary base with virtually no increase in short-term rates.
This modest increase in long-term interest rates in Japan suggested that bond-market participants didn’t believe inflation would be a problem, even with a substantial increase in the monetary base. Another measure of money-supply growth is M2, a broader measure of money that includes demand and time deposits. During the period of explosive monetary-base growth in the early 2000s, M2 in Japan grew by a paltry 1 to 3 percent (Figure 5). One explanation for this anomaly is that the economy didn’t want the BOJ’s money. A better explanation is that loans create deposits, and, without loan demand, there can be no deposit growth.
The Japan experience is but one example where excess monetary base growth has had no discernable impact on inflation. The demand for money — i.e., loan demand — plays a key role in determining how Fed policy affects the economy.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.