MSN Money | March 31, 2006
By Jim Jubak

The U.S. Federal Reserve made big news at the end of March. And almost nobody noticed. Here's the headline you didn't see:

• Fed kills M3, decides money supply doesn't count: Move raises risk of higher long-term inflation and new asset bubble

The March 28 interest-rate hike wasn't exactly unimportant. Stocks and bonds both took a hit that day because the language accompanying the Fed's 15th rate hike since June 2004 proved that those who had bet on "one more and done" were clearly wrong. The Federal Open Market Committee is now very likely -- an 88% chance, according to the futures market -- to raise rates again at its next meeting on May 10. The odds on a further hike at the end of June have started to climb as well. Higher interest rates in the future will put downward pressure on the prices of stocks and bonds.

The death of M3

No, the underreported story that, in my opinion, deserved headline treatment and didn't get it was the end of M3, on March 23. As the Federal Reserve had promised last November, the U.S. central bank will no longer collect or publish this most-inclusive measure of the growth of the U.S. money supply, although it will continue to publish narrower measures such as M1 and M2.

Why should you mourn the death of a statistical measure? Because inflation (unless you're a strict monetarist) has two causes:

• Cause 1: Prices go up when demand exceeds supply. This is the kind of inflation the Federal Reserve under Alan Greenspan and Ben Bernanke has targeted and is working to control with interest-rate increases that are intended to reduce demand in the economy to non-inflationary levels.

• Cause 2: Growth in the money supply produces inflation as the price of money itself fluctuates with changes in the supply and demand for money.

But the Fed -- under Greenspan, and so far under Bernanke -- has behaved as if money supply growth didn't matter and as if price inflation were all that mattered. Even as they have raised interest rates in an effort to slow the economy and reduce demand, they've continued to let money supply grow at close to double-digit rates. M3, the most inclusive measure of the money supply, grew at a seasonally adjusted annual rate of 8.7% in the three months from November 2005 to February 2006. That's faster than the annual rate -- 8% -- for the 12-month period beginning in February 2005.

In other words, as the Federal Reserve was fighting inflation by raising interest rates to 4.75%, from 4% in November 2005, it was letting the money supply grow by an inflationary 8.7%. While it was fighting inflation by raising interest rates to 4.75%, from 2.5% in February 2005, it was letting the money supply grow by 8%.

Origins of inflation

For me, something is wrong with this inflation picture.

Not according to the U.S. Federal Reserve, of course. The Federal Reserve's official policy, as articulated by officials such as Don Kohn, a governor of the Fed, at a recent conference sponsored by the European Central Bank, is that:

• Money supply isn't a good indicator of future inflation.

• While rapid growth in the money supply may be connected to asset bubbles such as the 2000 stock-market collapse, the connection is too full of uncertainties to manage.

• Measuring the money supply is too darn expensive and difficult anyway.

Because it's so hard to say exactly what money is today, a measure like M3 does seem antiquated.

But that makes it even odder, in my opinion, that the Federal Reserve would decide to kill off M3, the most inclusive of current money-supply measures, yet keep collecting the data for narrower definitions of money such as M1 and M2.

Rather than killing off M3, you'd think the Federal Reserve would be spending money to develop and publish data for an M4 and maybe an M5 to track the ebbs and flows of an even-more-expansive definition of money that includes some of the new forms of money that have been manufactured on Wall Street and in other global banking sectors.

You'd especially think that would be the case because the Federal Reserve has so publicly raised the possibility that the explanation for the current unusual combination of high economic growth and low interest rates is a global excess of capital. If that might be so, wouldn't it be useful to develop a standard monetary measure to track it?

But instead of expanding the definition of money, the Federal Reserve is contracting it.

I'm not generally a believer in Federal Reserve conspiracy theories. But in this instance, the conspiracy theorists make an intriguing point. The Federal Reserve decided to kill off M3, they argue, because it is the measure that shows the fastest growth in the money supply. For the 12-month period that ended in February 2006, for example, M3 grew at annual rate of 8%, but M1 grew by just 0.4% and M2 by 4.7%. Certainly, getting rid of M3 makes it harder to argue that the short-term inflation fighters at the Federal Reserve are actually very soft on long-term inflation. Maybe so soft that you could say they love long-term inflation.

Fuel for conspiracy theorists

The Federal Reserve conspiracy theorists go on to argue that this is exactly the kind of monetary policy you'd expect from the world's greatest debtor nation. Use your credentials as a short-term inflation fighter to convince global savers it's safe to buy U.S. dollars and U.S. debt, while at the same time supporting the long-term inflation that will cut the future value of that debt and thus let the U.S. pay back its current debt in less-valuable future dollars.

Of course, I'd never want to go so far as to put something like that in print. It's just too outlandish to believe.

So instead, let me offer up a more concrete fear. Although the Federal Reserve may be correct when it argues that there isn't a tight connection between inflation and growth in the money supply over the short-run, the data does argue, convincingly in my opinion, for a connection in the long run. In the long run, countries with faster-growing money supplies experience higher inflation.

And even worse, if the money supply grows fast enough, it provides the liquidity required for the runaway growth of asset bubbles, like the stock market in 2000. And, some would argue, like the U.S. real-estate or credit markets now.

Certainly the European Central Bank believes this. Its inflation policies are based on using a mix of economic data -- something like the Fed's mix of producer prices, job growth, confidence and wage rates -- to judge short-term inflation. This data feeds into the bank's target for price inflation of "below but close to 2%."

But the European Central Bank also looks at the growth of the money supply, its version of M3, when it sets interest rates. M3 growth accelerated to an 8% annual rate in February 2006, up from 7.6% in January, and the fastest rate since September 2005. That's one reason that European financial markets are so convinced that the European Central Bank will raise short-term interest rates again when it meets in May -- to 2.75% -- and why the futures markets have priced in hikes that would take short-term rates to 3.25% by the end of 2006.

The difference in the two banks' approaches has implications well beyond inflation, however. The European Central Bank is willing to sacrifice some short-term growth in order to head off the growth of asset bubbles and the damage caused when they deflate. The U.S. Federal Reserve has repeatedly declared its belief that, given the huge uncertainties in economic data, it is too risky to try to head off bubbles and it's better to clean up the mess afterward. Certainly that was the Fed's position in 1999: as equity prices rose at what Fed chairman Greenspan called an irrational pace, the bank refused to cut off credit to traders by raising margin requirements.

New developments on past columns

The trade deficit's deep bite: It's official. China now holds the largest foreign exchange reserves in the world. At the end of February, thanks to the country's most recent monthly trade surplus and continued inflows of foreign investment, China's reserves reached $854 billion. That inched China ahead of Japan, which held reserves of $850 billion. Zhou Xiaochuan, governor of the People's Bank of China, defended China's current policies, saying that his country was on the road to a basic balance in international trade but that it would take China two to three years to reach that balance. Besides, he noted, on a per capita measure, China's foreign reserves are quite modest. China's population was about 1.3 billion as of July 2005.

Editor's Note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. For suggestions to help navigate the treacherous interest-rate environment see Jim's portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.

E-mail Jim Jubak at jjmail@microsoft.com. 

At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.