The Fed Tightens the Monetary Noose

Steve H. Hanke

Today, the Fed defied President Trump’s irreverent Tweets. Indeed, the Fed did what it signaled it was going to do long before Trump pushed the “Tweet” button. Yes, the Fed — with all 10 members of the Federal Open Market Committee (FOMC) voting “yes” — increased the federal funds interest rate by 25 basis points to the 2.25-2.50% range. And, as night follows day, the U.S. equity markets, currency markets, and precious metals markets took a hit.

But, what does the Fed’s policy stance have in store for the course of the economy (read: nominal GDP)? For the answer to that question, I embrace the most robust national income determination model: the monetarist model. The course of the economy, when measured in nominal terms, is determined by the course taken by the money supply. Indeed, the positive relationship between the growth rate of the money supply and nominal GDP is unambiguous and overwhelming.

So, just what is the measure of money that is most suited for taking the temperature of the economy and forecasting its course? Is a narrow metric, like the monetary base (M0), the best? Or, should we focus on broad money metrics, like M3 and M4? For national income determination, the more inclusive the metric, the better. The most complete and accurate picture is developed when all the important components of money supply are included, not just a few.

To obtain money supply data is simple enough. Just go to the Fed’s monetary data base and pick the broadest money supply measure, and you will be ready to go. Right? No, it’s not that simple. First, since the Fed stopped reporting the M3 money supply measure in March of 2006, one is left with M2 as the broadest measure reported by the Fed. And, M2 is not very broad.

The Fed’s money supply measures are limited to rather narrow metrics, and that’s a problem. To obtain superior, broader measures, one must go to The Center for Financial Stability (CFS) in New York, where I serve as a Special Counselor. The CFS produces a detailed monthly report “CFS Divisia Monetary Data for the United States.” That report contains a broad money measure M4. It includes five more components than M2: institutional money-market funds, long-term deposits, repurchase agreements, commercial paper, and T-bills. These components are important because they all serve, in varying degrees, as money. To exclude them from a measure of money would be to exclude a great deal.

So, the CFS money supply metrics contain important components that are excluded in the Fed’s M2. In this sense, the CFS data are superior. But, narrowness is only the start of the Fed’s data problems.

What really separates the CFS measures from the Fed’s is that the CFS’s measures of money are not just a simple sum of the various components that make up the different measures of money (read the various M’s). The components of the money supply in the CFS’s measure are weighted by the degree of “moneyness” in each component. These weightings are the work of William A. “Bill” Barnett, the world’s leading expert on Divisia monetary aggregates. As a result of his work, the CFS’s weighted Divisia measures give a much more accurate picture of the money supply than do the Fed’s simple sum aggregates.

So, where are we today? The Divisia M4 growth rate is only 4.0% yr/yr. That rate is a bit on the weak side. Indeed, it is lower than it has been during the past year, and it is also below its trend rate for the past 30 years of 4.9%. This suggests that the Fed’s balance sheet unwind is resulting in a relatively “tight” monetary stance. The Fed is clearly tightening the noose, and with that, nominal GDP will slow.

Steve Hanke is a professor of applied economics at The Johns Hopkins University and senior fellow at the Cato Institute.