The Fed Gets Real on Money Supply : The breakdown of an old formula for regulation leads to use of actual interest rates.

Federal Reserve Chairman Alan Greenspan hinted this summer that interest rates will rise slightly before long. His statements would not be surprising if there were also signs of rising inflation. But data have continued to show very moderate price increases. As a result, many observers are puzzled about the Federal Reserve’s monetary policy.

In fact, there has been a significant shift in the Fed’s method for determining monetary policy. As Greenspan revealed in his recent congressional testimony, the Fed has changed its focus to targeting real interest rates, rather than the growth of the money supply. This has followed an apparent breakdown in the traditional relationship between total spending in the economy and the growth of money.

For most of the past decade, the Fed used a measure of money known as M2, which includes checking accounts, savings accounts and money-market mutual funds, to guide its actions. This was based on the evidence that an extra percentage growth in M2 has generally been followed by an extra percentage-point growth in total spending after about six months.

Twice a year, the chairman of the Fed has announced to Congress the broad range within which the Fed wanted to see M2 grow. When M2 appeared to be growing so rapidly that it might overshoot the upper limit of its target range, the Fed used its ability to manipulate short-term interest rates to slow the growth of money. Conversely, when M2 grew more slowly than the Fed wanted, it attempted to stimulate faster growth by reducing short-term interest rates.

In 1989, M2 began to grow more slowly than the Fed had targeted and interest rates were eventually brought down gradually. In retrospect, it is clear that the reduction in interest rates was too slow, both before and since the recent recession. Both M2 and, with it, total spending grew too slowly and the recovery has been extremely weak.

In the second half of 1992, the relationship between M2 growth and the subsequent rise in total spending broke down. While M2 rose at less than 1% during the first half of 1992, total spending continued to grow at a rate of more than 5%.

The traditional relationship broke down because many individuals and households reacted to the very low real interest rates by shifting funds out of banks and money-market mutual funds into short-term bond and equity funds not included in the M2 measure of money.

The Fed concluded last fall that the best strategy in the face of this shifting and possibly unstable relationship is to keep short-term interest rates steady. Since then, the Fed funds rate (at which banks borrow and lend to each other overnight) has been kept at 3%.

Now Greenspan has explained that in the future the Fed will focus on the “real” Fed funds rate--that is, the difference between the Fed funds rate and the rate of inflation. Since the Fed is now forecasting inflation of about 3.5% over the next year, the current Fed funds rate corresponds to a negative real interest rate. Greenspan believes, correctly, that as the economy approaches “full employment” (the lowest sustainable unemployment rate of about 6%), a negative real interest rate would cause inflation to rise. That’s why he has pointed to an upcoming increase in short-term rates.

The Fed is right to avoid blindly following an M2 target that is not currently useful. But its new real-interest-rate strategy is fraught with risk. The key point is that for any sustained period of time, the Fed can only control “nominal” magnitudes, such as the market rate of interest or the rate of inflation, while more fundamental economic forces determine the real inflation-adjusted magnitudes.

If the Fed tries to maintain a level of real interest rates different from the level at which supply-and-demand forces are in equilibrium, it will drive unemployment or inflation to higher and higher levels.

So while the short-term real interest rate can provide some useful information, it cannot serve as the single guide to making appropriate monetary policy. The Fed should continually re-examine whether the traditional link between M2 and subsequent total spending has re-established itself, allowing the Fed to use M2 again as the primary guide to monetary policy.

But that’s a technical matter. The important thing is that the Fed focus on continued gradual reduction in the rate of inflation. Our reading of Greenspan’s remarks is that he will try to do just that in the months ahead.