A Monetary Cross-Check on the Fed

Michael T. Belongia Peter Ireland

In December 2015, after keeping its federal funds rate target close to zero for more than seven years, the Federal Open Market Committee (FOMC) finally achieved “lift off,” raising the target to a range between 0.25 and 0.50 percent.  The Committee maintained that very low range for nearly all of 2016, waiting until last month before bringing the target rate up another notch, to its current band between 0.50 and 0.75 percent.  Will the Fed raise rates more quickly in 2017?  Our own analysis of monetary conditions suggests that the FOMC would be advised to continue moving gradually instead.

Minutes from the FOMC’s December 2016 meeting summarize the reasons for the second rate hike, with direct reference to the Fed’s dual mandate of maximum employment and stable prices.  

The unemployment rate has fallen to 4.7 percent, a value quite close to current estimates of the natural rate of unemployment.  Most FOMC members view the natural rate as a threshold beyond which further reductions in unemployment will exert upward pressure on inflation.  Thus, while inflation itself, measured at 1.4 percent using the Fed’s preferred price index for consumer expenditures, remains below the FOMC’s announced target of two percent, low unemployment has strengthened Committee members’ confidence that inflation will return to a value much closer to target in 2017. Indeed, projections accompanying the FOMC minutes indicate that several additional interest rate increases can be expected in the year ahead.

Clearly, the FOMC’s strategy continues to be shaped by the belief that the Phillips curve relation describes a tight link between unemployment and inflation – an idea we disputed in a previous column for E21.  The FOMC’s strategy rests importantly, as well, on the idea that interest rates serve most reliably as indicators of the stance of monetary policy, with continued low rates signaling that policy remains exceptionally accommodative.  Monetarist economists such as Milton Friedman often point out, however, that interest rates can provide a misleading view of the effects that monetary policy is having on the economy especially when inflationary expectations have become unstable.  Most famously, during the Great Depression, Fed policymakers mistakenly took very low interest rates to mean that they were doing all they could to support an economic recovery.  But a sharp contraction in measures of money showed, more correctly, that monetary policy was excessively tight, exacerbating rather than ameliorating the economic downturn.

Our own recent research outlines an alternative approach that uses the quantity theory and measures of money to gauge the stance of monetary policy, which we propose as a cross-check against more popular analyses built on the Phillips curve and interest rates instead.  Our empirical framework is organized around two observable variables: the Divisia MZM money supply as the measure of M on the left-hand side of the quantity equation MV = PY and nominal GDP as the measure of PY on the right.  Because nominal income is, by definition, the product of real GDP (Y) and the aggregate price level (P), it conveniently summarizes in one variable both sides of the dual mandate: maximizing output or employment and stabilizing prices.

Since 2011, Divisia MZM has grown at an annual rate between 6 and 7 percent, while nominal GDP has expanded by only 3.5 to 4 percent per year.  This comparison reveals that, instead of remaining constant as the simplest version of the quantity theory assumes, monetary velocity V has trended slowly downward over this period.  Our approach tracks these changes in V to estimate, in real time, the long-run value V* towards which actual velocity appears to be gravitating.  We use this estimate of V*, together with the data on Divisia MZM, to compute the target Q* = MV* towards which nominal income itself will converge.  When the gap between Q* and PY is positive, it indicates that past money growth is putting upward pressure on PY; accelerating nominal income growth will then close the gap.  Conversely, when Q* is below PY, past monetary restraint is putting downward pressure on nominal income.  The figure below plots this “nominal income gap” since 2000.

By our measure, monetary policy went from accommodative following the 2001 recession to highly contractionary before the financial crisis of 2007-08.  And while policy was appropriately expansionary during the crisis and recession that followed, its stance since 2010 appears approximately neutral.  This observation leads us to believe that nominal GDP growth is unlikely to accelerate markedly in 2017.  Assuming that FOMC members are content with nominal GDP growth between 3.5 and 4 percent – which, when split evenly, implies rates of real GDP growth and inflation between 1.75 and 2 percent – monetary policy seems well-balanced now.  If, however, the FOMC follows through with its plans to raise interest rates further this year, our monetary cross-check may provide early warning that they are moving too fast.