Inflation tip: watch money supply

These days, most analysts on Wall Street and the nation's monetary officials don't pay much attention to the growth in the nation's money supply. Yet the Federal Reserve's creation of new money remains vital to maintaining a vibrant economy without much inflation, at least in the long run.

The European Central Bank (ECB) and the Bank of Japan pay far more attention to money than the Fed does.

Right now, some economists reckon the Fed has been slightly too generous in pumping out new money in the past five years. If so, the inflation rate may rise modestly in coming months.

"A bit more tightening" is needed, says Bennett McCallum, an economist at Pittsburgh's Carnegie-Mellon University.

But the recent negative reaction of the stock market to what's seen as a new threat of inflation and thus higher interest rates is perhaps exaggerated. "We don't think the Fed is dramatically off course," Professor McCallum says.

His "we" refers to the Shadow Open Market Committee (SOMC), a small group of private economists founded in 1973 to evaluate the policy choices and actions of the Federal Open Market Committee (FOMC), the Fed's policymaking group.

Three decades ago, there was a vigorous debate between two schools of economics: the Keynesians, named after British economist John Maynard Keynes, and the monetarists, led by Nobel Prize-winner Milton Friedman.

The monetarists were winning the debate because their predictions, using a measure of money as a key forecasting tool, were proving more accurate than those of the Keynesians, who gave prime attention to variations in interest rates.

During the late 1960s and 1970s, Wall Street waited breathlessly every Thursday, after the stock market closed, on a Fed report on the growth of money.

"Today, no [financial] commentators talk about it," notes Henry Kaufman, a veteran Wall Street economist who was for a long time dubbed "Dr. Doom" because of his gloomy economic prognostications. (Many computerized models of the economy still incorporate money-supply figures into their formulations.)

Those with long memories will recall that in October 1979, a year when consumer prices rose 13.3 percent, the new Fed chairman, Paul Volcker, announced the Fed would henceforth control the money supply rather than interest rates in its anti-inflation policy. As the Fed slammed on the brakes, short-term rates zoomed up to 18 percent briefly.

The startling move - though not followed up fully in a monetarist, money-watching fashion - did burst the inflationary bubble. From a political standpoint, it was brilliant. The move gave other FOMC members and the White House cover for a stern monetary policy that resulted in a deep recession.

On the positive side, Mr. Volcker tamed inflation to the benefit of his successor in 1987, Alan Greenspan.

Half-joking, McCallum says the twice-a-year sessions of SOMC economists "are not so much fun" because Fed policymaking has "improved tremendously." In the past, monetarist economists often charged the Fed with worsening booms and busts in the economy by its policies.

Now, when the St. Louis branch of the Fed issues its monthly Web publication, Monetary Trends, any sharp, long-term changes in money supply growth are hard to detect in the charts and tables. Such changes might presage worse inflation or a recession ahead.

"It appears interest [in the publication] has gone up some," says a Fed economist.

Yet the Fed itself again manages monetary policy, not by managing money supply, but by buying or selling financial assets in the markets to fix a short-term interest rate on overnight, interbank loans, the Federal Funds rate.

Last month, the Fed pushed up that rate to 5 percent. Economists are debating whether the Fed will shove it up another 0.25 percent later this month in the latest preemptive move against inflation, or leave it alone because of signs the economy is slowing.

Mr. Kaufman holds that the financial markets have too much liquidity. Thus the Fed will have to "make things tighter than generally expected" by eventually hiking the Fed Funds rate to 6 percent.

Such a high rate could hit the stock, bond, and housing markets.

Contrariwise, economists at Goldman Sachs, a major investment bank, see the current "core" inflation rate (a measure that ignores energy and farm prices) as "less than meets the eye." So they figure the Fed will pause in raising interest rates when its policymakers meet June 29.

The Fed and most private economists in the United States stopped obsessing over money-supply figures in the 1980s when innovations in the financial system became so great that money-growth numbers proved to be no longer a good short-term economic predictor. Financial markets became globalized. New instruments of credit multiplied. Money substitutes, such as credit or debit cards and home-equity loans boomed. "The meaning of money has been blurred," says Kaufman.

A basic measure of money called M-1, that includes currency in circulation plus demand deposits in commercial banks, no longer adequately covers total purchasing power in the nation.

Indeed, the St. Louis Fed, regarded as a center for monetarist-inclined economics, now looks more seriously at money supply figures only every half year.

A recent study by William Dewald, a retired Fed monetary expert, does find that money growth relates over the longer term - say, five years - to changes in real and nominal output of goods and services, and to inflation.

So, money still makes the world go round - but with a more substantial lag.