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Monetarism Is Back. It May Not Last. Some on Wall Street predict bad times because of an unprecedented drop in the money supply James Mackintosh By James Mackintosh

The Federal Reserves approach to money supply has evolved over the past several decades.

Disciples of Milton Friedman are delighted: Monetarism seems to be working again, three decades after the economic theory was ditched as the guiding light of central bank policy. Their happiness is tempered by concern, however, that the supply of moneythe core variable at the heart of monetarismis shrinking. This suggests the Federal Reserve, Bank of England and European Central Bank have gone too far and bad times are ahead. The Fed focused on controlling the money supply under Chairman Paul Volcker from 1979, but slowly moved back to concentrating on the price of money, the interest rate. In 1993, the Fed stopped targeting the money supply entirely, as Chairman Alan Greenspan told Congress that the long-run relationship between money supply and inflation seems to have broken down. Pandemic declared 2012 '15 '20 '25 -10 -5 0 5 10 15 20 25 30 % CPI - ALL URBAN: ALLDec. 30, 2011, 3.0621, 3.062% Pandemic declared 2012 '15 '20 '25 -1 0 1 2 3 4 5 6 7 8 9 10 % This directly contradicts the thesis of monetarism, as set out by Friedman, a winner of the Nobel Prize in economics. Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output, Friedman wrote in 1970. Greenspan was right, and for a quarter of a century Friedman was wrong. There was essentially no link between any of the various measures of money supply and inflation through the 1990s, 2000s and 2010s. The pandemic and the emergency response has reinvigorated monetarists, especially investors, who point out that the massive growth in the money supply predicted inflation with a lead of 18 months. The slowdown in the money supply then predicted lower inflation, again with a lead of 18 months. 2011 '15 '20 -10 -5 0 5 10 15 20 25 30 % U.S. M2 U.K. M4ex* Eurozone M3 Japan M2 Monetarists are now concerned about an unprecedented fall in the money supply year over year, at least as measured by M2, which adds bank notes, checking-account balances, retail money-market funds and low-value time deposits. In the eurozone and the U.K., the money supply is also falling, including on broader, M3 and M4 measures that add other forms of money, such as business bank accounts, but are no longer produced by the Fed. It would be foolish to ignore the monetary shrink, said Matthew McLennan, co-head of global value at First Eagle Investments. Monetary policys starting to look pretty tight. The Nobel Prize laureate Milton Friedman regarded inflation as a monetary phenomenon. The question is whether looking at the money supply offers a useful guide to how far the Fed is restricting the economy, or if interest rates and bond yields are the better guide. The argument for focusing on quantity is simple: When inflation is high, it is the money supply that matters. A paper by the Bank for International Settlements this year concluded that theres no link between the quantity of money and inflation when inflation is low. But in a high-inflation regime, money supply is a near-perfect indicator. Looking at the money supply would have helped economic predictions after the pandemic, not only for individual countries but also when comparing inflation between countries. Advertisement - Scroll to Continue The countries that printed the money had the inflation, said Richard Woolnough, a fund manager at M&G Investments, comparing developed with emerging markets. The countries that didnt print, or couldnt print, didnt. The argument against a focus on the money supply is that the cost of money is more important for personal and business decisions that drive the economy. Bank lending is no longer constrained by reservesthe base money issued by the Fedso the supply of money depends on demand at any given interest rate rather than on how much the Fed creates. The leap in inflation wasnt because of monetary policy alone, either; it took off in large part because money was handed out by the government as stimulus. In other words, inflation was due to fiscal, not monetary, policy. When the Fed hugely increased the money supply with QE2 from 2010 onward, the move didnt lead to runaway inflation, despite the fears of economists and investors at the time. Similarly, large amounts of money-printing by the ECB did little to raise inflation for years until the pandemic unleashed government spending. N. Preview Subscribe Isabel Schnabel, a member of the ECBs executive board, said recently that it was possible both for the soaring money supply in 2020 to be a useful indicator of the inflation that came, and for the shrinking money supply now to provide little reason for concern. She argues that some of the measured money destruction might be no more than a rebalancing of savings into higher-interest, long-dated accounts and assets such as government bonds, which arent captured in the traditional measures of supply. Money as measured by M2 or M3 goes down, but not because households or businesses are being more cautious. She points out that theres little link between the size of money-supply moves and the size of recessions. That is a reason to be less worried about the fact that the current shrinkage is the biggest ever. Even believers in the predictive power of the money supply have to accept that the measures we have give only the roughest of approximations of how far people have run down their pandemic-era savings, how willing banks are to lend, whether CEOs are committing to new investment projects, and other drivers of the economy and inflation. SHARE YOUR THOUGHTS What do you think the future holds for monetarism in the world economy? Join the conversation below. At the very least it is too early to be sure that the apparent 18-month lead of money supply into inflation since the pandemic will continue. And outside of a crisis such as 2008, when there was an actual shortage of money, I continue to think it is the cost of money, rather than imperfect gauges of how much money is in circulation, that we should watch. If monetarism is back, the ghost of Friedman has a miserable message: Buy cash and safe bonds, steer clear of stocks sensitive to the economy and dont borrow too much. If the money supply doesnt matter, then were back to the years long-running debate about whether the Fed has raised rates enough, and will keep them high for long enough, to finally slow the economy. Monetarism offers a simpler answer, but it was wrong for a long time before being right. It might be wrong again.