ECB head Trichet defended his stance to continue the use of monetary aggregates as a guide for monetary policy. Not only does he still look at M3 while many central banks like the Fed no longer even report it, but he also states that he employs it as a key policy tool. The high growth in M3 was one of the reasons for raising interest rates by the ECB. Either Trichet is a dinosaur from the 1980’s or he has a level of vision about monetary economics that is lacking in many of his peers.
It should be noted that monetarism has never been a policy prescription that has held the fancy for central bankers. The early 1980’s was a period of excitement for monetarists that has never been matched, yet there may have been a feeling by many monetarist that the acceptance of aggregates as a key tool by the traditionalists was closer to a shotgun wedding, a marriage of convenience given the wild changes in inflation. An extreme view would be that the following of money was just a smokescreen to raise interest rate to unprecedented levels. Nevertheless, money aggregates is still fundamental to our thinking about extremes in inflation.
Is there a place for M3 or any monetary aggregate in our current global economy? That answer is hard to say for three reasons. One, financial innovations have changed the velocity of money. Two, the linkages in the global economy have made the flow of money more difficult to monitor. Three, inflation has been low so we have not seen the type of fluctuations in money like the 1980’s.
The use of credit cards and ATM’s by consumers as well as different corporate borrowing behavior means that the use of money has changed and the channels of credit have also gone through significant adjustment. While this is an issue, the focus has to be on whether these changes in velocity are stationary and predictable. The jury is mixed. Much of the velocity work shows a money-GDP relationship which may be a random walk. The casual link between GDP and monetary aggregates has also been questioned. Clearly, changes in velocity mean that the time lag between a change in money and a change in inflation or GDP will differ. Using rules of thumb between money increases and inflation increases is perilous.
The world economy is more open especially with respect to money and credit, so measures of money have less meaning than what we have seen in the past. Money flows can change with financial flows around the globe. Attempts to limit credit through raising rates can result in foreign money entering the economy and diminishing the impact of policy.
Finally, the value of tracking money is reduced because the fluctuations in money and the changes in inflation are less volatile than what has been seen in the 1980’s. Using money to direct policy is a blunt instrument. When inflation is double digits, cutting money will solve the problem. The link between high inflation and money is very strong, but the correlation is much lower when we are at lower and less volatile levels.
The issue is determining the best measure of money through finding the one with the closest link with business and inflation cycles. Is it M3 as suggested by Trichet? Hard to say. There has always been a strong debate between those who suggest a broad money target versus those who want to focus on a narrow definition, but following the monetary and credit aggregate signs should not be ignored. If it is growing quickly and inflation in moving above target, credit aggregates should be examined. While I do not have the expertise of Trichet or his critics, following credit cycles is still fundamental to how the economy should be tracked.
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