Is the Fed monetarist?

By: Patrick Minford, Cardiff Business School

Is an economy a monkey dancing on a high wire or it is a supertanker that takes 50 miles to turn around? Probably the answer is somewhere in between and closer to the second. To judge from the gyrations in the equity and bond markets, and commentators in the FT, it should be the first; they are screaming recession from the rooftops. To judge from the consensus of forecasters it is the second; they have pencilled in a moderate growth rate for the US in 2008 of just under 2%.

 

What has been the shock? There has been a collapse in US sales of homes which has triggered a sharp fall, by now longstanding, in construction. Additionally there was a nasty spike in market interest rates with the sub-prime banking crisis; this lasted for a fairly short period because the Fed offset it quite quickly with cuts in its lending rate. Subsequently the Fed has cut its rate a lot further so that today market rates are down to 3.5% and indeed anticipating yet further cuts.

 

The consequences of this shock have been a slowing of consumption and a modest rise in unemployment. It is likely that Q4 growth in the US will come in low. But it is worth noticing that real retail sales growth has continued at 4% on a year earlier, while capital goods orders remain strong and capacity utilisation remains high. With wage growth quiescent, profits are also at high levels. Purchasing managers’ surveys continue positive, if marginally so for manufacturers, still firmly positive if moderated for services.

 

Now let us wheel in the Fed, which is being roundly criticised by the old testament prophets around the world whose view remains obdurately that ‘inflation is only sleeping’, that it ‘was hiding in asset prices’, that its is like a cat whose ‘head once out of the bag, proves impossible to stuff back in’; and a host of other delightfully religious statements, with no apparent connection to mundane macroeconomics. Actually the Fed is facing a weakish economy and no indication of longterm inflation pressure, under a regime which though not explicitly one of inflation targeting is widely believed to be effectively such. Looking at the last decade the Fed’s inflation target seems to be a range between 2-3%, about in line with most other inflation targeters once one aims off for the variety of indices being used. With the principal cost component, wages, clearly being set in line with this target, the Fed really has no need to get aggressive with the big stick. Instead it can respond flexibly to the ups and downs of the economy, much as would happen under a money supply target, where a fall off in money demand would no doubt trigger a very sharp fall in interest rates.

 

Indeed it can be argued that the Fed is closest in delivery to the precepts of Milton Friedman, arch monetarist targeter of money, than any other extant central bank. Compare it say to the ECB which stolidly sticks to the interest rate it last set regardless of any events at all, be they the money supply, inflation, or the state of the real economy; no monetarists they! Indeed it is hard to know what to call the ECB; they live in a world of permanent confusion, where religion, politics and a sort of economics jostle pathetically, with occasional statements emerging from the Delphic M. Trichet, that leave us none the wiser what they are up to.

 

Returning to the outlook for the US economy, one can say that it is substantially underpinned by the Fed’s concern to let the price of money vary sensitively with supply-demand conditions in the money market. Rates will be allowed to fall until the economy and the demand for money it generates start to stabilise around steady growth above 2%. This is both immensely reassuring and in line with how money markets are supposed to work when there are firm monetary targets. Of course unfortunately we have found that measuring money reliably is too tricky a task for us to rely on it for targeting- anyone who needs convincing of that should review the travails of Mrs. Thatcher’s governments with different targeting regimes; with grateful relief her successor discovered inflation targeting which finally worked reliably.

 

As for other economies, forget talk of decoupling from the US. The US is the free market for the world, generally open to trade, provided US protectionism can be confined to the usual suspects in Congress and the northern manufacturing states. If it went into recession, the emerging markets would soon grind to a halt; their impressive intra-trade is basically one in inputs and capital goods for the outputs that go to the US market- yes, they go to other developed countries too but most of them, and worst of all the EU, are unreliable recipients of import surges and easily tipped into protectionism.

 

So the key component of the current outlook is that for the US and that rests heavily on the shoulders of the Fed. Thank goodness for sanity, and a total absence of religion, in its hallowed halls!

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