Monetary Policy: Part 3 - The Stable Decades (cont.)

The Federal Reserve spent the four decades after WWII targeting the level of interest rates, and in particular the overnight fed funds rate, with what could only be considered disastrous results. The 50's were marred by recession after recession, four in all. The 60's saw modest inflation result in government-imposed price controls followed by a resurgent inflation when they were dropped later. And the 70's saw a serious recession followed by the infamous "stagflation" when a stagnant economy was paired with near-double-digit inflation and long-term treasury rates bordering on 10%. The early 80's saw nearly 20% short rates, 14% long rates, and another serious double-dip recession. This track record hardly qualifies as a success for the Federal Reserve in that era.

But Stability Reigned in the Operating Rules

Yet, that was the time frame during which the Fed's operating rules remained relatively stable. It was also, not coincidentally, a time when a growing number of both monetarists and investors became interested in monetarism as a theory that explained what was happening to both prices and economic activity.

This was a time when so little changed in the system's banking rules that patterns began to appear, patterns from which deductions could be made and conclusions drawn. In fact, by 1980 a few prominent economists were beginning to home in on what was really going on with monetary policy. Then the introduction of NOW accounts blew it all out of the water.

Lessons to be Learned from the Stable Decades

At this point I'm switching to first person for a bit because this is a personal story of discovery. By 1975, as bond portfolio manager at the Tennessee Consolidated Retirement System in Nashville TN, I had become seriously interested in monetary theory. At that time the Fed of St. Louis branch of the Federal Reserve was the keeper of the Monetary Base, a measure of bank reserves, currency in circulation, and an adjustment factor that they calculated to account for the occasional (then quite minimal) changes in reserve requirements from time to time. They put the Monetary Base forward as a leading indicator of both money growth and the economy, a concept that I found interesting and useful.

Then, sometime in early 1976 I had a Eureka moment. Inflation by then had accelerated significantly and people were finding that cash didn't go as far as it used to go. Or, more accurately, the cash in one's wallet didn't last as long as it needed to before the next regular infusion. It suddenly dawned on me that the currency we all carry, or did then before debit cards at least, was an exceptionally stable amount and was increased only reluctantly, and in response to inflation that had already occurred. That was the insight, the Eureka! For at that time currency in circulation was a large component of the Monetary Base, but the Monetary Base was considered a leading indicator of money growth, economic growth, and inflation. But, clearly, people were reacting to inflation by increasing the money in their wallets, not the reverse. Virtually no one rationalized that inflation would be high over the next year so they'd better prepare for it by starting to carry more cash.

Assuming you buy that rationale, which I obviously did, the first question that arises is: "What is a lagging indicator of inflation (cash in your wallet) doing in a leading indictor of inflation (the monetary base)?" The obvious answer, to me at least, was that it doesn't belong there at all. So I took it out.

That left a much smaller number that consisted only of Total Reserves plus the Fed of St. Louis's adjustment factor, a number that I began to refer to as Effective Reserves. And that was a far more interesting number.

The Role of Effective Reserves and the Economy

In a future series of posts I might reanalyze the data from 1946 to 1980. I did it years ago and later discarded the original data. Today, that data is not readily available due to the many seasonal adjustments that have been applied over the succeeding years. I've looked at the current data and some of what I'll now describe can still be discerned, but it's not as convincing as the originally-reported data. I'll leave it at that.

What I found was that whereas the twists and turns in the M1 Money Supply (which was followed closely by most monetarists at that time) would indeed presage both economic turns and inflation, it was far less sensitive than Effective Reserves.

In fact, almost without fail for over 35 years any economic slowdown was presaged by a plateauing and sometimes a downturn of Effective Reserves that began almost exactly six months earlier. And if Effective Reserves turned back upward at some point (as it inevitably did) the economy would begin to recover almost exactly six months thereafter. There was a point in the late 1970's where you could count on a surprising drop in retail sales, for example, just by noting that it had been nearly six months since Effective Reserves topped out.

Effective Reserves and Inflation

What I found with inflation was equally interesting, and informative. If Effective Reserves and the GNP Deflator (its name at the time) were each indexed to 100 in the late 1940's the Deflator then tracked Effective Reserves with a lag for the next 40 years, with one notable exception. That was during the price control era of the early 1970's. President Nixon implemented price controls when inflation was running what later turned out to be a relatively modest 4% or so (as I recall) and inflation naturally slowed, or at least prices stopped rising.

However, Effective Reserves did not stop their steady rise and so the spread between the Effective Reserves line and the GNP Deflator line began to widen, with Effective Reserves outpacing the Deflator. This marked an incipient inflation, as it turned out. When price controls were eventually removed inflation picked up, eventually rising faster than the Effective Reserves line, for it had some "catching up" to do. Thus, ironically, the Carter inflation of the late 70's could actually have been a hangover effect from the Nixon price control era. In the end, the lines converged once again.

Volcker than took over the Fed and tightened viciously, driving interest rates on fed funds to nearly 20% because that was the theory the Fed operated under. Rates had to go up to get inflation under control.

But inflation was already under control according to the Effective Reserves measure. It had already plateaued and the Deflator had nearly caught up to it. According to the Effective Reserves measure, inflation was conquered and the economy was in trouble. The aftermath consisted of a serious double-dip recession and the commencement of a sustained drop in the inflation rate for almost 20 years resulting in the Fed of the early 2000's having to worry about possible deflation.

Question: Why Would Effective Reserves Track with the Deflator in a Growing Economy?

That is, why wouldn't a growing economy require a larger money supply to keep prices stable instead of falling. This question nagged me a lot during the 70's and early 80's and the best I could come up with, since the two measures tracked so reliably, is that the banking system has a productivity factor just like any other industry.

So, if economic growth required, say, 3% more money each year just to hold prices stable, and the banking industry got, say, 3% more efficient at pushing people's money around from place to place, perhaps it would even out. That's obviously speculation on my part, but it seems reasonable, especially since we had 40 years of relatively stable banking rules so any adaptations would be gradual, rather than sudden reactions to changing rules.

Conclusion

The evidence indicated to me that turns in Effective Reserves presaged both economic turns and changes in the rate of inflation. So if the Fed wants to keep inflation under control while not causing undue declines and accelerations in economic conditions, they should have simply targeted Effective Reserves rather than the fed funds rate.

By targeting, I mean that they should have sought to keep them stable, not rising or falling, either of which tends to influence economic growth. Instead, let the economy react to real factors, rather than fed-induced ones, and worry mainly about keeping inflation in check.

In the next post I'll describe what I learned about money growth in response to Fed actions, and how it is that I believe that maintaining a stable money supply was a trivial matter under the operating rules of the stable decades, although that was rarely achieved due to the theory the Fed was operating under at that time.

Continue to Monetary Policy: Part 4 - Solving the Mystery of Money Growth