The Best Things in Life Are Free?

JACKSON HOLE, Wyo. -- The table below shows four things.

  • Growth in the M2 measure of the money supply. M2 money growth has accelerated for five straight years.
  • Growth in nominal (or current-dollar) gross domestic product. Note that nominal (or current-dollar) variables are unlike real (or constant-dollar) variables in that they have not been adjusted for inflation.
  • Growth in the M3 measure of the money supply. M3 money growth has also accelerated for five straight years.
  • Growth in total bank loans. Loan growth has accelerated for two straight years.

It is no secret that credit and money are making the economy go. Do the money numbers in particular have anything to say about the future of the economy and

Fed

policy?

Recall this

nugget from the July 1998

Humphrey-Hawkins

testimony.

For several decades before 1990, the velocities of M2 and M3 defined as the ratios of nominal GDP to the aggregates behaved in a fairly consistent way over periods of a year or more. M2 velocity showed little trend but varied positively from year to year with changes in a traditional measure of M2 opportunity cost, defined as the interest forgone by holding M2 assets rather than short-term market instruments such as Treasury bills. M3 velocity moved down a bit over time, as depository credit and the associated elements in M3 tended to grow a shade faster than GDP. In the early 1990s, these patterns of M2 and M3 behavior were disrupted, and the velocities of both aggregates climbed well above the levels that were predicted by past relationships.

In other words, here the Fed was noting that the usefulness of the

MV = PQ

equation plunged to zero in the early 1990s because velocity -- and it may help some people to think of velocity as the number of times per year that the average dollar turns over in making transactions -- was no longer proving stable.

(For those not familiar with it, the MV = PQ equation states that the quantity of money M times velocity V equals the price level P times real output Q. Recognizing that PQ equals nominal GDP

any real variable equals its nominal counterpart divided by some price level, so it must be true that a nominal variable equals its real counterpart times that price level and solving for velocity, V = nominal GDP/M; this is the ratio to which the Fed is referring in the first sentence in the quote above. Here it is easy to see the intuition behind the quantity theory of money: Provided that velocity is fairly constant, increases in the money supply will translate directly into increases in nominal GDP. When velocity is not constant, however, as was the case in the early 1990s, the MV = PQ equation proves useless.)

But also in the July Hawkins testimony, the Fed noted the following.

However, since 1994 the velocities of M2 and M3 have again moved roughly in accord with their pre-1990 experience, although their levels remain elevated. The recent return to historical patterns does not imply that velocity will be fully predictable or even that all movements in velocity can be completely explained in retrospect. Some shifts in velocity arise from household and business decisions to adjust their portfolios for reasons that are not captured by simple measures of opportunity cost. Some shifts in velocity arise from decisions of depository institutions to create more or less credit or to fund credit creation in different ways. All these decisions are shaped by the rapid pace of innovation in financial institutions and instruments.

Fair enough. What seems like a Return to Normal might well prove to be only a head fake, especially in light of rapid financial-sector change. It's silly to argue otherwise.

Yet it's just as silly to ignore the fact that velocity is taking on added importance at the Fed. Even eight months ago the Fed noted that

In light of the apparent return of velocity changes to their pre-1990 behavior, some FOMC members have been giving the aggregates greater weight in assessing overall financial conditions and the thrust of monetary policy.

And last month it noted:

Given continued uncertainty about movements in the velocities of M2 and M3 (the ratios of nominal GDP to the aggregates), the Committee would have little confidence that money growth within any particular range selected for the year would be associated with the economic performance it expected or desired. Nonetheless, the Committee believes that, despite the apparent large shift in velocity behavior in the early 1990s, money growth has some value as an economic indicator. Indeed, some FOMC members have expressed the concern that the unusually rapid growth in the money and debt aggregates in 1998 might have reflected monetary conditions that were too accommodative and would ultimately lead to an increase in inflation pressures. The Committee will continue to monitor the monetary aggregates as well as a wide variety of other economic and financial data to inform its policy deliberations.

All this really means is that the more hawkish members of the FOMC are entirely pissed about big money growth. But as long as G isn't as concerned about it as they are, it doesn't matter (in a policy-action sense) what they think.

That doesn't mean you shouldn't watch the monthly money numbers closely -- you should (they are usually released on the second Thursday of the month). The Ms currently sport notable accelerations on their 1998 growth rates.

And because they always show some kind of a material deceleration ahead of a business cycle peak, it is hardly yet clear that the economy is done accelerating -- let alone flattening or decelerating.

Side Dish

Headed to

Las Vegas

today. How can one be anywhere else during tourney time?