Money supply: is the Fed really in charge?
Every Friday afternoon the financial and political gurus in Washington, Wall Street, and elsewhere await the announcement of the weekly money supply figures. They then use this information as an indicator of the current status of Federal Reserve Policy. The change in the nation's money stock is dutifully reported by the media on the evening news and the following day in the newspapers. These reports include appropriate incantations about the meaning of this latest figure with respect to the outlook for the economy and Federal Reserve policy.
There is a growing body of evidence, however, that indicates such exercises are futile.
The Fed can affect economic activity through the expansion or contraction of the growth in the money supply by adding or removing reserves through the purchase or sale of securities. Many financial and political observers argue that the Fed can instigate fairly rapid changes in the money supply and thereby the economy by manipulation of the reserve level in the banking system.
Unfortunately, the Federal Reserve cannot directly adjust the level of money held by the public. That decision is made by economic units (banking and nonbanking public) that face uncertainty -- not only as to the future but what current information implies about the future. When the Fed injects reserves into the system, what does it mean? Is it permanent or a temporary phenomenon soon to be reversed?
A study recently released by this author and J. Kimball Dietrich of the University of Souther California shows that the conventional thinking is wrong.
First, nearly nine months elapses from the time there is a change in reserves by the Fed to the time a change occurs in the banking sector. Second, banks do not respond by increasing loans and thereby the money supply but rather reduce their own borrowing (borrowed reserves). It takes about another nine months for the public to adjust their portfolios leading to changes in the money supply. Thus, it takes nearly 18 months for Fed operations to affect economic activity.
What happens in the short run? This same study shows that the Fed accommodates changes in the banking system induced by activities outside of the financial system. That is, the Fed does not initiate policy changes but rather reacts to those events in the economy external to both the banking sector and Federal Reserve policymaking. Even this accommodation takes six months to affect the economy.
These findings are also consistent with several studies showing that the stock market forecasts economic activity approximately six months hence. None of this, though, is under the control of the Federal Reserve.
What conclusions can be drawn concerning Federal Reserve policy and economy?
* Federal Reserve initiatives can only affect the economy in the very long run. Attempts to "fine-tune" the economy through monetary policy are doomed to failure. Calls by various segments of the political economy for short-run intervention by the Fed are inappropriate and should be strongly resisted. The current policy of maintaining adequate growth of reserves should be continued.
* The Fed should be cognizant of the lag effect of its operations. Trying to adjust to the current situation could be counterproductive.
* The public should not pay too much attention to the weekly money supply announcements and should instead look at the longer-range movements of growth in borrowed and unborrowed reserves. Likewise, the Fed should be more open about its operations so that the public will better understand the role of the monetary authorities in the national economy.
Given these observations, what then is the outlook for the money supply and the national economy?
Some guesses can be made based on forces already at work in the economy. It looks as if there will be a strong expansion of the money supply and the economy beginning in late 1981 and continuing into 1982. Using past history as a guide, there does not appear to be much that the Fed can do about this scenario. The Federal Reserve will be accomodating this expansion and the stock market should be moving upward reflecting this expansion in the economy by September.
Whether this expansion in the money supply will be inflationary is dependent on the nonbanking sector of the economy expanding its productive capacity. Preliminary evidence suggests that businesses are increasing their investment activity. If this trend continues, the forthcoming expansion can lead to real economic growth without exacerbating inflation.