Should a modern central bank still care about money?

M3 and Credit in the euro area.

Does money still matter for modern monetary policy? If you thought the beast was dead, you could not be more wrong. The subject of whether monetary aggregates matter for a central bank remains one of the big issues of modern monetary economics, but the discussion about this subject differs fundamentally from the discussion several decades ago
This is a distinctly European issue in the sense of the major central banks in the world, only the European Central Bank still makes explicit reference to money in its policy formulation. The ECB has adopted a two-pillar strategy, in which standard economic analysis, based on a neo-Keynesian forecasting model, forms the first pillar, while monetary analysis constitutes the second pillar of policy. The ECB is sometimes described as monetarist, partly because it tried to model itself on, and borrow credibility from, the German Bundesbank.
But this is not a 1960s or 1970s style discussion about monetarism. No one in the right mind would want to target the money supply, given the experience of money supply targeting in the past. The proponents of money have a far more moderate goal. They argue that money sends some useful signals that a non-monetary analysis might not pick up, and that this would justify a separate analysis of monetary trends. This is the framework of the debate that is currently taking place – and the subject of a remarkable conference organized by the European Central Bank in Frankfurt on November 9-10.
The modern economist view on money is best summarized by Larry Meyers, a former governor of the US Federal Reserve, who was quoted by Mervyn King : “Money plays no explicit role in today's consensus macro model, and it plays virtually no role in the conduct of monetary policy.”
Most modern central banks, including the ECB itself, employ neo-Keynesian models in their economic analysis. These models have no explicit reference to money. Some old-fashioned monetarists have argued that these models are by definition incomplete. Since inflation is a monetary phenomenon, they surely cannot capture the true cause of inflation. Other have voiced the concerned that a cash-less model would ultimately lead us to the high inflationary period of the 1970s.
Michael Woodford of Columbia University summarised those misgiving in a paper he presented at the conference.

There are a variety of misgivings that one might have about the soundness of cashless models as a basis for policy analysis. One sort of doubt may concern their theoretical coherence, or at least their consistency with a fundamental principle of economic theory, the neutrality of money. One might suppose that a model that makes no reference to money must either be inconsistent with monetary neutrality, or leave the general level of prices indeterminate so that such a model could not be used to predict the consequences for inflation of alternative policies. Alternatively, one might suppose that the models are coherent as far as they go, but that they are incomplete.

Woodford goes on to show that the standard neo-Keynesian model, even though it makes no reference to money, can determin the rate inflation. Furthermore, as Woodford writes:

Does the fact that this model determines the equilibrium price level without any reference to the money supply imply a violation of the long-established economic principle of the neutrality of money? It does not. The most important aspect of monetary neutrality, and the one that represents a genuinely deep principle of economic theory, is the proposition that decisions about the supply and demand of goods and services should (if decision makers are rational) depend only on the relative prices of different goods, and not on the absolute price (price in terms of money) of anything. This has an important implication for the theory of inflation, which is that one cannot expect there to be a theory of the general price level (at least, not one founded on rationality and intertemporal general equilibrium) for a world without government in the way that one can, for example, speak of what the relative price of oil would be in a hypothetical world in which there were no government petroleum reserves or other government interventions in the market for oil. The equilibrium price level, or alternatively the real purchasing power of the monetary unit, depends crucially on government policy, and more specifically on monetary policy: it is only the fact that the central bank's actions are not independent of the absolute price level that gives a nation's currency unit any specific economic significance.

Another argument frequently used in defence of the ECB “monetary pillar” is the credibility it has inherited from the Bundesbank, which used to be, or rather pretended to be a monetary targeter. While the credibility argument has some merit, it can at best justify the use of money in the early days of the ECB, or as Woodford put it:

But however prudent such a choice may have been when the new institution's strategy was first announced, in 1998, it hardly follows that it should never be possible to dispense with pious references to monetary aggregates. At some point, the institution should have earned its own credibility and no longer need to borrow this from an association with past policies of another institution. Of course, it will remain important that the ECB not appear to change its strategy abruptly or capriciously, if its own past successes are to count as a basis for confidence in the institution in the future. But evolution of the details of its strategy should be possible without risking the credibility of the Bank's core commitment to price stability, especially when this evolution can be explained as a result of improved understanding of the means that best serve that unchanging end.

Can there be still a justification for money in the light of Woodford’s devastating critique? If it can, then it is not due to the alleged short-coming of the neo-Keynesian framework inability to take proper account of inflation. One has to find real-world phenomena that the neo-Keynesian is incapable to generating. One such phenomenon is a boom-bust cycle in the stock market. The debate moves on the transmission chanels of monetary policy.

Larry Christiano, with Robert Motto, and Massimo Rostagno, argued that an inflation targeting central bank can actively contribute to a boom-bust cycle. This argument reflect a frequent criticism of the policy of the Federal Reserve according to which the central bank did too little to prick the asset price bubble (see also a separate Eurointelligence Briefing Note on this subject). They write:

Our results are as follows. We find that - within the confines of the set of models we consider - it is hard to account for a boom-bust episode (an episode in which consumption, investment, output, employment and the stock market all rise sharply and then crash) in a model that abstracts from nominal frictions. However, when we introduce an inflation targeting central bank and sticky nominal wages, a theory of boom-busts emerges naturally. In our environment, inflation targeting sub-optimally converts what would otherwise be a small economic fluctuation into a major boom-bust episode. In this sense, our analysis is consistent with the view that boom-bust episodes are in large part caused by monetary policy.

The argument in favour of money in some respects relates to the areas the neo-Keynesian models cannot reach. Money matters because the transmission mechanisms themselves may have a live of their own. This argument was elegantly summarised by Lucas Papademos, vice-president of the ECB.

The strong conclusions on the irrelevance of money in the conduct of monetary policy derived from the New Keynesian models are not a consequence of the key and attractive features of those models – the role of expectations and the more solid microfoundations – but they reflect underlying assumptions concerning the role of money and of financial intermediaries in the economy. One such simplifying but limiting assumption is that real money balances do not affect aggregate demand directly. Another is that financial intermediation, which is important for credit provision and liquidity creation, has no effects on economic activity and prices other than those resulting from changing lending rates which move in parallel with all market rates. In these markets, there are no informational asymmetries or liquidity and credit constraints affecting the behaviour of economic agents, which is not the case in the real world. And movements in asset prices, that in reality can be affected by liquidity conditions, do not affect directly or via wealth affects spending decisions. I am sure that as the new framework for monetary policy analysis is extended, to allow for a sufficient degree of realism on the role of money and its counterparts – notably credit – in the economy, the relevance of money in the conduct of monetary policy will be revealed and restored. Research carried out at the ECB and elsewhere aims at incorporating a richer financial sector into dynamic stochastic general equilibrium models, in order to study the role of financial variables in the conduct of monetary policy. And we should be looking forward to the findings of this research.
It is, of course, legitimate to ask whether these additional refinements that I am suggesting will turn out to be quantitatively significant. My expectation – and, I should say, my rational expectation based on the observation and assessment of economic reality – is that they are likely to be important. But the extent of their relevance in practice can only be judged on the basis of the available evidence, which can perhaps be better assessed in the context of the new theoretical framework and the associated dynamic stochastic general equilibrium models being developed.

Another influential modern proponent of money is none other the Charles Goodhart, whose devastating criticism of monetarism has greatly influenced the debate during the 1980s and 1990s. Goodhart has recently proposed a corollary of his Law according to which the relation between money and inflation might stabilize again as central banks no longer target money. His argument is that money alone is no a useful indicator, but that the combination of money and bank lending has a much higher significance. For example, the 2001-2003 above-average growth in M3 in the euro area was accounted for almost entirely by portfolio shifts – from capital and equity into short-term money instruments. But the present phase of above-average monetary expansion – since 2004 – is accompanied by a strong increase in bank lending to the private sector, and especially to households. Bank lending has been growing at annual rates of more than 10 per cent. This expansion, according to Goodhart, is indeed meaningful, and may have implications for future inflation.

In its 2007 survey on the euro area, the OECD argues that recent empirical evidence weakened two of the rationales for the use of monetary indicators by central banks: money demand functions were less stable recently than during the 1990s, and the leading indicator qualities of money have diminished. The OECD suggests that the ECB may be therefore be placing too high an emphasis on money in its two pillar-strategy. Furthermore, the strategy poses a communication challenge, as it is unclear to outside observers how the ECB uses the monetary pillar, and how much weight it attaches to it.

The OECD is making four precise recommendations:

1. The ECB should publish additional quantified medium-term inflation forecasts, using money-based models.
2. The ECB should publish the low-frequency components of M3, which it uses internally.
3. The ECB should extend the horizon of its forecasts.
4. It should try to quantify the risk-distribution around its forecasts through a fan chart for example.

This debate is far from settled. What can be ascertained with some degree of confidence is that this debate will continue for some time to come, that the European Central Bank will continue to rely on monetary analysis as its second policy pillar, while the Federal Reserve and the Bank of England will not.