There's An Easy Way to Grade the Fed
We've shunted it aside since 1971, but there's is a better way to manage the dollar. It involves a return to one of the most fundamental principles in economics: supply and demand. Discussions about monetary policy almost always begin with talk about the Federal Reserve. In recent years these discussions have focused on things like Quantitative Easing, Operation Twist and "artificially" low interest rates. The financial media scrutinizes Ben Bernanke's speeches and FOMC releases for signs of any change in policy. This conventional wisdom focuses only on the supply side of the equation. Ignoring the other half of the equation, demand, is extremely dangerous and can easily lead one to the wrong monetary conclusion.
Despite its dual mandate, the only job of the Federal Reserve should be to match the supply and demand for dollars. When these are properly matched, the price level is unchanged and the value of the dollar is stable. When there is more supply than demand the price level rises and the value of the dollar falls. We call this an inflationary mismatch. Conversely, when there is more demand than supply the price level falls. We call this a deflationary mismatch. Viewed through the lens of matching the supply and demand for dollars, analyzing what the Fed is doing at any moment in time becomes much simpler than dissecting Ben Bernanke's commentary. It also gives us a better view into the consequences of the monetary policy being implemented.
To find dollar mismatches, one must begin with a measure of both the supply and demand for dollars. The supply of dollars is relatively straightforward and accepted by most as measured by the monetary base. The Federal Reserve has direct control over the monetary base and can directly change the supply of dollars in the system. The demand for dollars is harder to measure. We follow in the footsteps of famed economist Art Laffer in using M1 as an approximate measure of the demand for dollars. M1 includes all notes and coins (currency) and demand deposits (checking accounts.) By examining the relationship between the monetary base (supply) and M1 (demand) we can begin to see if there is a dollar mismatch. For example, if M1 (demand) was increasing because economic growth was surging and people demanded more dollars for transacting, the Federal Reserve should accommodate that increase in demand by increasing the monetary base (supply).
From September 2008 until September 2010 the Federal Reserve created an inflationary dollar mismatch. They were supplying more dollars than the system demanded. This can be seen by looking at the Fed's own weekly data release of M1 and monetary base. During that time period, the year over year growth rate of M1 (demand for dollars) averaged 17% while the year over year growth rate of the monetary base (supply of dollars) averaged 62%. This inflationary mismatch, or what Art Laffer calls "excess base," should have increased the price level and decreased the value of the dollar. It did. From Q3 2008 to Q1 2011, the price of gold doubled $700 to $1400, the price of light crude oil tripled from $30 to $90 and the price of No. 11 sugar tripled from 10 cents to 30 cents per pound.
Since 2011, conventional wisdom claims that the Federal Reserve has continued running an extremely "loose" monetary policy. The media has played up Ben Bernanke's nickname of "Helicopter Ben" and assumed that money printing will create inflation far into the future. While this may be true, the analysis falls short since it ignores what has been going on with the demand for dollars.
From 2011 until present, the year over year growth rate of M1 (demand for dollars) averaged 16% while the year over year growth rate of the monetary base (supply of dollars) also averaged 16%. Far from an inflationary mismatch, monetary policy has been stable. In 2012 alone, the year over year growth rate of M1 (demand for dollars) averaged 16% while the year over year growth rate of the monetary base (supply of dollars) averaged 5%. Given this slight deflationary mismatch, the price level should be flat to down and the value of the dollar flat to up. They are. Over the past 12 months gold is roughly unchanged at $1700, light crude oil is down from $95 to $90 and No. 11 sugar prices are down from 23 cents to 21 cents per pound.
What has been happening for over a year is what former Fed governor Wayne Angell calls "quantitative neutrality." Flat commodity and gold prices tells us there is a match between dollar supply and demand. While the Fed has produced a stable monetary policy, we think they are completely unaware of the match. There is no evidence they are intentionally doing price level targeting. They have accidentally done the right thing, and it is not likely they will continue doing so because they are not looking at the demand for dollars side of the equation. By only focusing on supply, the Fed can be dangerously wrong about the effects of monetary policy. Currently, this mistake shows up as the Fed thinking they are too easy when, in fact, they are not.
What will happen to the supply and demand for dollars going forward? We believe that the Fed is very unlikely to tighten policy by decreasing the supply of dollars. In both their words and actions, the Fed has taken steps to keep stable or increase the monetary base. Further, their model attempts to set interest rates based on unemployment data. Unemployment is a lagging indicator and in no way helps the Fed see and match the supply and demand of dollars. The recent acceleration of growth in M1 (demand for dollars) may reverse for two key reasons. First, the European panic may subside. Much of the recent increase in the demand for dollars resulted from Euro holders seeking out safer currencies. As fear in Europe subsides, U.S. dollar demand may fall. Second, a large slowdown in U.S. GDP would dramatically decrease the demand for dollars as economic transactions slow. This GDP slowdown is assured given poor tax and regulatory policies coming from Washington. These poor policies act as retardants to growth and barriers to economic activity. As dollar demand falls and the dollar supply stays flat or increases, an inflationary mismatch will likely occur again.
The Fed, by only watching supply and not demand, will likely continue producing both inflationary and deflationary mismatches. Proponents of a gold standard are often criticized for relying on such a "barbarous relic." What such criticism misses is that a gold standard is an excellent way to automatically match the supply and demand for dollars in real time. A gold standard removes the risk of politicians and unelected Fed officials making a mismatch mistake. When gold is rising, the Fed gets the signal that there is more supply than demand for dollars and can remove monetary base. When gold is falling, the Fed gets the signal that there is more demand than supply for dollars and can add monetary base. We applaud the good work done in this area by people like Chuck Kadlec and organizations like TheGoldStandardNow.com. They know much more than we do about how best to return to a currency that is backed by something other than promises of politicians.
Getting the right monetary policy is the "just one thing" for prosperity. Getting it wrong is an unavoidable tax on every one of us. History shows us that monetary policy goes beyond party lines. Clinton and Reagan ran strong dollar monetary polices; Nixon, Carter, Bush and Obama all ran weak dollar monetary policies. To help prevent further weak dollar policy, please sign our White House petition to restore sound money and prosperity. 150 signatures will get this issue posted on the White House website and 25,000 will get a direct response from the administration. We have until December 14th to get there. Politicians from both parties don't want to have this conversation. Let's take back the power they have seized.