Economist Milton Friedman once quipped that talking about inflation without mentioning the money supply is like writing a book about love without mentioning sex. But that’s exactly what the Federal Reserve Board is doing today.
Even as the Fed has taken unprecedented steps to bolster the U.S. economy by purchasing Treasurys, its economists ignore the effects that growing the monetary base will have on the money supply. All that means is that the Fed isn’t paying attention to how rapidly the currency in circulation (plus Federal Reserve deposits) is growing compared with the money that is ready and available to be spent outside the Federal Reserve. Given the historically close correlation between the monetary base and money supply, the monetary base’s large jump in recent years needs to be examined.
The Fed and its policymakers now run the risk of failing to control inflation when it does appear. Volatility in the bond markets may ensue, further destabilizing the global financial system. Long-term uncertainty about future price levels is a major concern. When people can’t reasonably predict how much goods and services will cost in the future, it is much more difficult to plan for investment, which in turn can hamper economic recovery.
How did we get to this point? The Fed has been rapidly expanding the monetary base (by buying Treasurys), ostensibly to counteract deflation as a result of the financial crisis. Many experts have accepted that this “quantitative easing” can be managed to produce healthy, modest inflation.
But that assumption is false. The recent expansion of the U.S. monetary base is arguably already inflationary if one accepts the idea that the economy would be experiencing deflation were it not for quantitative easing.
Those who’ve studied economics have been taught the Quantitative Theory of Money (M*V equals P*Q), which holds that the money supply multiplied by the velocity of money (or the number of times the same dollar is re-spent in a year) must equal the price levels of goods multiplied by real production. For years after the runaway inflation in the 1970s, the Fed studiously monitored the money supply and successfully operated in accordance with Friedman’s oft-quoted adage, “Inflation is always and everywhere a monetary phenomenon.” In the short term, Friedman stated, an increase in the money supply will boost real production, but in the longer run its impact is felt mainly in price levels — in other words, inflation.
The Fed is no longer capable of operating on this principle — even if it desired — because it no longer accurately monitors the money supply. M2, which represents the supply of money and close substitutes for money, has lost its value as a meaningful predictor, in large part because M2 does not reflect the increasing use of financial innovations such as home equity lines, credit cards and brokerage accounts. Meanwhile, in 2006 the Fed altogether stopped tracking M3, a broader money supply metric that includes M2 along with large-timed deposits — apparently because the oversight process was deemed too onerous.
Fed Chairman Ben Bernanke has also personally downplayed the importance of tracking the money supply. When M2 is stable, he argues that no inflationary pressures lurk on the horizon. When M2 jumps up, as it has very recently, Bernanke ignores the metric and sticks to the same “no inflation” script. In an interview last year, Bernanke stated emphatically that “the money supply is not changing in any way,” noting that he thinks “this fear of inflation ... is way overstated.”
But M2’s stability in relation to the monetary base is a red herring. And Bernanke’s position is paradoxical. He still appears highly certain that the Fed can appropriately contract the money supply, at the right time, to prevent high inflation — stating this year that his confidence in this matter is “100 percent.” How can he be certain of the causal relationship between the monetary base and the money supply?
In fact, Bernanke’s supreme confidence that the Fed can drain excess liquidity from the system at the right time to maintain price stability makes the risk of a tail event — such as hyperinflation — even more likely. He himself foreshadowed today’s predicament in 2003. “The idea that monetary policy had long-run [real] effects … proved not only wrong but quite harmful,” Bernanke said then, referring to the Fed’s mistaken embrace in the 1960s and 1970s of the notion that monetary policy could be used to effect real outcomes. Bernanke observed that this “contributed significantly to the Great Inflation of the 1970s — after the Great Depression, the second most serious monetary policy mistake of the 20th century.”
As we embrace yet more quantitative easing, Bernanke needs to better monitor and understand monetary aggregates — before it’s too late.
Gerber is the vice chairman of the Woodrow Wilson International Center for Scholars and CEO of Hudson Bay Capital Management LP. The views expressed here are his own.