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This post is a bit less about Presidents than usual, but its a follow-up to last week’s post on the non-relationship between the money supply and interest rates. (That post appeared both at the Presimetrics and Angry Bear blogs. In that post, I noted that the Federal Reserve tends to move the money supply monthly and seasonally with no corresponding change in the fed funds rate. For example, the Fed will increase the money supply in December to make sure there’s adequate money in circulation for the Christmas shopping season, and yet interest rates don’t move at all.

This week, I want to expand on that, and point out that I wasn’t entirely accurate. There actually is a relationship between interest rates and the money supply, but its not the the one taught in textbooks. The textbook relationship, as I noted last week, can be described like this:

The Fed determines what the Federal Funds interest rate should be. If the Fed wants to reduce interest rates, it will create money out of thin air and use it to buy bonds. Because there is more money competing to buy bonds, the interest rate bonds have to pay falls. At the same time, the added money sloshing around becomes cheaper for anyone to borrow, whether they’re issuing bonds or not. On the flip side, if the Fed wants to raise interest rates, it sells bonds. That forces anyone else trying to sell bonds to raise interest rates to compete. Additionally, because the Fed retires the money it gets paid for the bonds it sells, that process reduces the amount of money available in the economy, making it harder to come by and hence more costly.

In other words, the money supply and interest rates are negatively correlated. An increase in money supply leads to a decrease in interest rates, and a decrease in the money supply leads to an increase in interest rates. There is an alternative story, but it only applies to high inflation environments. If you’re in Argentina in 1982, for example, the money supply is increasing so fast that any little bit of new money translates immediately into inflation and higher interest rates.

So there’s the theory, what everyone knows is true. But what really happens? For that, as always, we cut to the data. The Federal Reserve’s Economic Database (FRED) reports the federal funds rate going back to July of 1954. For the money supply, we used M1 from 1959 to the present, and the money stock for years before that.

The graph below shows the correlation between the 12 Month Percent Change in M1 and the Fed Funds rate in the same period, one month later, two months later, etc.:

The graph shows that the correlation between the percentage change in M1 over a year ending in a given month and the Fed Funds rate in the same month is about 14%. The correlation between the annual percent change in M1 and the Fed Funds rate in the next month rises to 16%, and so forth. The 1 year change in M1 has a higher correlation with the Fed Funds rate 36 months later than with any lag on the Fed Funds rate. In plain English, increases in M1 lead to increases in the Fed Funds rate, and decreases in M1 lead to decreases in the Fed Funds rate. That doesn’t sound at all the textbooks tell us we should expect in a world that isn’t suffering from hyperinflation.

Now, you may be thinking to yourself… maybe that relationship is a function of the fed trying to react to a slowing economy. Strip out months in which the economy is in recession, plus the three months leading up to and the 3 months leading out of the recession, and the graph looks like this:

Notice… the correlation drops a wee bit, but the shape of the curve is pretty much the same. Once again, it is fairly evident that this does not conform in any way to the classic textbook story.

So what is going on? My guess is that in the U.S., for the period for which we have data, in general:

1. changing the money supply has had no direct relationship on the Fed Funds rate
2. changing the money supply has had a direct effect on the economy; increasing M1 (actually, real M1 per capita) causes the economy to grow more rapidly, and decreasing the real money supply causes the economy to grow more slowly or contract
3. because increases in the (real) money supply cause the economy to grow more rapidly, eventually an increase in the money supply will lead the Fed to raise interest rates in an attempt to slow the economy (to avoid inflation). On the other hand, because reductions in the (real) money supply lead to slower economic growth or economic contraction, these reductions will eventually lead the Fed to lower interest rates to try to get the economy to grow more quickly.

Step 2 is something we cover in the book, but I hope to write another post showing that soon.

Correction August 9, 2010
The second graph was mislabeled in the original post.

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2 Responses to “The Non-Relationship Between Interest Rates and the Money Supply, Part 2”

  1. Steve Roth says:

    Mike, I’m wondering if this demonstrates the efficacy of a still-incomplete metaphor I’ve been pondering: between managing the economy and flying an airplane.

    Non-pilots share a popular misconception (watch them play with flight-simulator software and you’ll see it pretty much without fail). They think that:

    To go faster you throttle up.

    To go higher, you lift the nose (with the elevators).

    When in fact exactly the opposite is true. You control altitude change with the throttle, and control speed with the elevators.

    Let’s apply this to the economy:

    GDP = altitude
    Interest rates = speed

    Money supply = throttle
    ?? = elevators

    Or similar.

    Is this useful?

  2. Mike Kimel says:

    Steve,

    I cannot comment on flying a plane. However, I think the situation is similar to what you describe, but a bit different.

    Both the ff and the MS affect the economy. And in theory, ff and MS affect each other. In practice, given how little anyone pays attention to the MS numbers, provided things aren’t pushed too out of whack, MS doesn’t actually have a direct effect on ff. Thus, where everyone thinks the Fed has one monetary tool, it has two.

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