None of the Fed’s Business

The latest Commerce Department report and FOMC press release have, as usual, led to a flood of commentary concerning the various economic indicators that the Fed committee must have mulled over in reaching its decision to put off somewhat longer its plan to start selling off assets it accumulated during the course of several rounds of Quantitative Easing.

Those indicators also inspire me to put in my own two cents concerning things that should, and things that should not, bear on the FOMC’s monetary policy decisions. My thoughts, I hasten to say, pay no heed to the Fed’s dual mandate, which is itself deeply flawed. But then again, since that mandate allows the FOMC all sorts of leeway in making its decisions, I doubt that it would prevent that body from following my advice, assuming it had the least desire to do so.

I have a simple–some may call it quaint–way of deciding whether some information supplies reason for the Fed to either sell off or buy more assets. Here it is: does the information offer reliable evidence of either a shortage or a surplus of nominal money balances?

Why this criterion? Because of two more quaint ideas. The first is that, notwithstanding the contorted arguments that contemporary monetary economists resort to in order to avoid admitting it, monetary policy is fundamentally a matter of altering the nominal quantity of monetary balances of various sorts available to banks and the public, starting with the quantity of base money. The latter quantity is, in any case, the thing that the FOMC decides to expand, or to contract, by its deliberations, whether it expresses its decision in terms of “Quantitative Easing” or in terms of some interest rate target.

The last quaint idea is that, just as a dose of vitamin D can do a world of good to someone suffering from rickets, while too much can prove toxic, monetary expansion, though the best solution to problems that have their roots in a shortage of money, is the wrong medicine otherwise. Call it crazy if you like, but that’s my belief and I’m sticking to it.

So, those indicators. Real GDP growth, first of all, slowed to a miserable 0.2% during the last quarter, or less than one-tenth the previous quarter’s figure, and just one-25th of the quarter before that.

A bad number indeed. But considered alone the number supplies no grounds for Fed easing, for the simple reason that it doesn’t tell us why real GDP growth is so low. If its low because of a money shortage, more money is called for; if its low for other reasons, it isn’t. More information, please.

Here’s some: it was a rough winter, labor disputes closed some West Coast ports, and oil has been dirt cheap. But what have such things got to do with monetary policy? Can a dose of monetary medicine make up for a winter storm, or a strike? Is cheap oil a reason for tightening money, so as to keep general prices from sagging, or one for loosening it to provide relief to domestic energy companies or to counter “weakness in the global economy”? Hard to tell, isn’t it? But that, I say, is because when one gets down to brass tacks such changes in the real economic circumstances ought in themselves to be none of the Fed’s concern.

What’s more, and though the claim may strike many readers as paradoxical, the same can be said about changes in the CPI. Although inflation is still below the Fed’s target, core CPI inflation has been inching up, and the 5-year forward expected inflation rate has been hovering just above the Fed’s 2-percent target for some months now. Surely that means that Fed policy is itself on track, right? Well, no, because these numbers could reflect either a revival of aggregate spending, which would indeed carry such an implication, or, despite the oil glut, a reduction in aggregate supply, which would not.

If all these bits of information shouldn’t shape the FOMC’s actions, what should? The statistics that come closest to serving as reliable guides to whether monetary policy is too tight, too loose, or at least roughly on track, are those that concern neither real developments nor prices but spending. When money balances are abundant, that fact is reflected in increased spending, because when people and businesses find themselves flush with money balances, they tend to dispose of those exceeding their needs by using them to buy goods or securities. If, on the other hand, people and businesses find themselves wanting larger money balances, they try to build them up by spending or investing less.

Slice it any way you like, Q1 spending was down. Way down. The annualized growth rate of consumer spending, which was 4.4% during the last quarter of 2014, or not far from its Great Moderation average, fell to just 1.9%, while business spending dropped from 4.7% to 3.4%. But the annualized growth rate of NGDP, a much broader measure of spending, experienced the sharpest decline, to just one-tenth of one percent, bringing the full-year forecast down from 3.8% to 3.6%. Some of this decline can be written off to winter doldrums, and hence as transient. But much of it can’t.

In short, the only facts that deserve to be considered approximate indicators of whether monetary policy has been too tight, too loose, or on track, suggest that it’s too tight. The others– whether they refer to the weather, or output, or dollar exchange rates, or the CPI and its variants, or stevedores’ discontent–are so many red herrings, and ought therefore to be considered perfectly irrelevant. Whenever FOMC members or any other monetary policymakers refer to such irrelevancies, they must do so either because the press expects them to, or because they are confusing things that the Fed should try to do something about with ones that shouldn’t be any of its business.

By saying all this, do I mean to say that, if the FOMC would just keep a sharp eye on spending, ignoring everything else, we would have sound monetary policy? Not for a minute. The reason, in part, is that spending statistics are themselves imperfect guides to the state of monetary policy, for too many reasons to go into here. More importantly, so long as the policymakers aren’t obliged to conduct policy according to a single, unambiguous target, their decisions will remain shrouded by uncertainty that is itself a big drag on prosperity.

But there’s more to it than that. Even if the Fed were somehow legally committed to target NGDP, or some other broad spending measure, from now on, and even if the measure were itself reliable, it wouldn’t solve our monetary troubles. And that’s because the monetary system itself is dysfunctional, and severely so. If it weren’t, it wouldn’t take more than $4.5 trillion in Fed assets to keep spending going at a reasonable clip. The defects are partly traceable to policies–including some of the Fed’s own–that discourage banks from making certain kinds of worthwhile loans, while encouraging them to hold massive excess reserves.

It’s owing to the crippled state of our monetary system, and not to any ambiguity in relevant indicators, that I myself have grave doubts concerning the gains to be expected from further Fed easing, or even from implementing a strict NGDP targeting rule, under present conditions. For if the experience of the last several years is any guide, it may require still more massive additions to the Fed’s balance sheet to achieve even very modest improvements in spending; and an NGDP-based monetary rule that would serve as a license for the Fed to become a still greater behemoth would not be my idea of an improvement upon the status quo.

You see, unlike some economists, although I’m happy to allow that an increase in the Fed’s nominal size, which is roughly equivalent to a like increase in the monetary base, is neutral in the long run, I don’t accept the doctrine of the neutrality of increases in the Fed’s relative size. I believe that Fed-based financial intermediation is a lousy substitute for private sector intermediation, and that as it takes over, economic growth suffers. The takeover is, in other words, financially repressive.

Which means that the level of spending is, after all, not the only relevant indicator of whether the Fed is or isn’t going in the right direction. Another is the real size of the Fed’s balance sheet relative to that of the economy as a whole, which measures the extent to which our central bank is commandeering savings that might otherwise be more productively employed. Other things equal, the smaller that ratio, the better.

And there, folks, is the rub. If you want to know the real dilemma facing the FOMC, forget about the CPI, oil prices, and last quarter’s weather. Here’s the real McCoy: NGDP growth is too low. But the Fed is too darn big.