The accumulating signs of an economic slowdown in recent weeks have, in the eyes of many, confirmed the Federal Reserve’s bias for pausing with interest-rate hikes. If economic growth is fated to become tepid, goes the reasoning, it will take the edge off inflation’s momentum.
The conceit buried in this school of thought is that the supply of money carries marginal sway on inflation’s course. That’s a disturbing view for monetarists, who hold that inflation is a phenomenon driven by changes in the money stock relative to the economy.
Among the main lessons embedded in this belief is that inflation and rapid and/or dramatic price increases aren’t necessarily one and the same. A shift in supply and demand moves prices. This has nothing to do with inflation, counsel the monetarists. Rather, an uninformed rise in the stock of money (i.e., a rise that’s more than the general economic conditions require for maintaining an orderly functioning of the economy) is one that ultimately elevates prices, but for reasons that are detached from supply and demand trends.
A new paper that preaches the value of seeing inflation as a monetary phenomenon comes from Edward Nelson of the St. Louis Federal Reserve. The research (The Great Inflation and Early Disinflation in Japan and Germany) documents that Japan and Germany in the 1970s witnessed an inflation that peaked relatively early and generally stayed lower compared with other nations in the West, notably the United States. He concludes that the “German and Japanese experiences in the 1970s indicate that once inflation is accepted by policymakers as a monetary phenomenon, the main obstacle to price stability has been overcome.”
The topic of debate before the house today is whether the “main obstacle” to price stability has been conquered in the collective mind of the Fed’s leadership. The current head of America’s central bank, to cite one example, has gone on record explaining that as the economy slows, so will inflation. Backing up that outlook with action, the Fed on August 8 put rate hikes on hold, an act that’s widely expected to have a repeat performance on Wednesday, when the FOMC meets again to consider the proper state of money’s price.
In fact, there are instances in history when an economic slowdown didn’t deliver a commensurate drop in inflation, the 1970s being the egregious example. America, in particular, suffered from so-called stagflation during that decade. Nelson finds that Germany and Japan suffered less. The reason is mostly due to decisions about money supply in those countries, he counsels.
That brings us to the observation that the rate of money supply is again heading up in the United States. The M2 measure of the nation’s money stock advanced by 4.9% over the past year through September 4–the highest since mid-July, according to Fed data. This is what one might expect when interest rates stop rising. Deciding if it’s also the right policy at the right time, assuming it continues, is another matter.
Of course, confirmation or rejection of the Fed’s current policy will come only after months and years, as opposed to the days and weeks that investors seem to think is the appropriate period for analysis. For that reason, we remain hopeful that the central bank will do the right thing in time, and that the recent trend in M2 isn’t necessarily indicative of things to come in the long run. What’s more, if inflation does in fact continue trending down, the risks of M2 growing lessen.
In the meantime, there is history to consider, including a variety of outcomes that central banks have dispensed over time by way of a variety of strategies. Some in the central banking system are studying that history. Only time will tell if those in the upper echelons are also availing themselves of the opportunity.


  1. Bond investor

    JP, many economists look at Annual Change in Real M2 (M2 adjusted for past twelve months’ inflation). Real M2 grew just 1.1% for the year ended 6/30/06.
    Furthermore, you may want to extend the history of your M2 chart. In the 1960s and 70s, nominal M2 growth was in the 7-10% range – significantly higher than today’s levels.
    Of course, the usual caveats about M2 versus MZM and other monetary aggregate measures apply. M2 in 1960 may be quite different than M2 today, because of additional credit sources, higher monetary velocity, other types of “near-cash”…

  2. Jim Picerno

    Bond Investor,
    I agree that at the moment the change in money supply isn’t a threat. Nominal GDP grew by an annualized 6.3% in the second quarter, safely above the 4.9% rise in M2 over the past year. The gap is closing, however. We’ll see.

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