In an interesting recent paper and blog post “Money Still Matters,” Michael Belongia and Peter Ireland report new empirical results with relevance to monetary policy. They show that the Divisia index of the money supply (not M1 or M2) has effects on the economy over and above the effects of the short term interest rate.
The results suggest that central bankers—as they look into alternative strategies for monetary policy—should consider some kind of money growth rate rule, at least as a supplement to the interest rate rules which have been the focus of research and practice for many years.
I agree with this view, and have for a long time pushed back against the trend of central banks—including the Fed—to ignore money growth. In situations where the interest rate hits the lower bound or more generally in situations of deflation or hyperinflation, I have argued that central banks need to focus on a policy rule which keeps the growth rate of the money supply steady. In a 1996 paper, for example, I recommended that “Interest rate rules need to be supplemented by money supply rules in cases of either extended deflation or hyperinflation.”
Belongia and Ireland point out that my early work on policy rules in the 1970s was completely in terms of money growth rules. That is true, but why the change toward interest rate rules? In their brief history of the 1980s and 1990s, Belongia and Ireland seem to provide an answer with a summary of my 1993 policy rule paper which they say “showed how well the Fed adjusted its funds rate target in response to movements in output and inflation during the late 1980s and early 1990s. The debate was closed. A new consensus, prevailing to this day, placed interest rates instead of money at the heart of all monetary policy discussions.”
But that Fed decisions were fairly close to some interest rate rule during such a short span of time was not my rationale for proposed interest rate rule. Rather research in monetary theory was the rationale. It was the implication of empirically estimated structural monetary models (with rational expectations and rigidities) that I was developing and working with in the 1980s. They had exchange rates and long term interest rates as well as short term interest rates with both internal and external dynamic stochastic shocks.
These models showed that interest rates rules would work better, at least with the range of shocks observed in the United States. This result first came out of research I was doing at the Philadelphia Fed with Nicholas Carlozzi, but the close connection between money growth rules and interest rate rules was very important in my view and I stressed it often. Different types of models and views on the monetary transmission mechanism led to similar conclusions so it was a robust result. In one of his last research papers Milton Friedman argued that the Taylor rule for the interest rate worked well because it was a way to keep the growth rate of the money supply constant, another way to make the connection between money growth rules and interest rate rules.
I argued that interest rate rules need to be placed within a band. Outside that band the central bank should rely on money growth rules. In simulating the multi-country empirical model at Stanford in the 1980s we took account of the zero bound on the interest rate, switching to money growth. And this is what I recommended in 2009. However, the series of on-and-off quantitative easing that began in 2009 was never aimed at keeping money growth steady or even at keeping it from falling, which is clear in the erratic behavior of M2 (see here) or Divisia, as Belongia and Ireland show.
In order to go from the interesting empirical results of Belongia and Ireland to a policy strategy, more research on alternative policy rules is needed. Are there structural models where alternative policy rules with money growth work better? What are those rules? Are they robust to other types of models? Such research led to the types of policy rules that are now the focus of so much attention. In my view it will lead to improvement in these rules, and in this regard it is useful to recall where policy rules for the interest rate came from in the first place.