Board of Contributors: Goose the Money Supply
When Alan Greenspan appears before the Senate and House Banking Committees later this month, a primary focus of his testimony will be the Fed's target for money supply growth during the current year. The decision on that rate of increase will be made during the next two days by the Federal Reserve Open Market Committee.</br></br>There's a good reason that the Federal Reserve is required to report on its target for the growth of the money supply rather than its target for interest rates. The change in the growth of the money supply is a good indicator of where the economy is likely to be headed in the near future. While it is certainly not a perfect indicator, the increase in the broad M2 monetary aggregate (that includes small time deposits and money market mutual funds as well as checking account deposits and currency) is far better than interest rates as a guide to the future growth of total spending in the economy.</br></br>As a rough rule of thumb, experience shows that the rate of growth of total nominal gross domestic product is approximately equal to the rate of increase of M2 six months earlier. Although there have been variations in this relation from year to year, over the past two decades nominal GDP has grown at an annual rate of 8.5% while the stock of M2 has grown by 8.7%. Recent experience also conforms quite closely to this general rule: Total nominal GDP rose 3.2% from the fourth quarter of 1990 until the fourth quarter of 1991, while M2 increased by 3.3% from the second quarter of 1990 to the second quarter of 1991.</br></br>The slow growth of nominal GDP last year helped to bring down inflation. But even with only a 3% percent rise of the GDP price deflator during 1991, the 3.2% nominal GDP rise left room for real GDP growth of only 0.2% from the fourth quarter of 1990 until the fourth quarter of 1991. A decline of GDP in the first quarter of 1991 was followed by a resumption of growth in the second and third quarters but then a fourth quarter in which real GDP rose only 0.3%. For the year as a whole, real GDP in 1991 was nearly 1% lower than in 1990. This recent slowdown would probably have been avoided if the Federal Reserve had provided faster growth of M2 earlier in the year.</br></br>Looking ahead, the level of economic activity during the first half of 1992 is likely to show very little if any increase because of the very slow growth of the money supply in the second half of 1991. Since M2 grew at an annual rate of only 1.3% from the second quarter of 1991 until the final quarter of the year, the rule of thumb based on past experience implies that nominal GDP will also rise only 1.3% during the first half of 1992. Unless the inflation rate drops below 1.3%, that simple forecasting rule implies no real growth in the first half of 1992.