The Wall Street Journal

November 20, 2006

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How a Friedman Theory Works
In Europe: Some Central Banks
Target Money-Supply Growth

November 20, 2006; Page A2

FRANKFURT -- Of all the legacies left behind by Nobel Prize-winning economist Milton Friedman, who died last week in San Francisco at age 94, the idea that central banks should focus on money supply to manage inflation is one that largely fell out of fashion years ago. Now, though, some policy makers in Europe are taking a second look.

World-wide, central bankers laud Mr. Friedman for laying the framework for modern monetary theory, and most of them accept his view that inflation is largely a result of money-supply growth. In the late 1970s and 1980s, many central banks, including the Federal Reserve, followed Mr. Friedman's prescriptions, which called for maintaining a steady rate of money-supply growth to produce low inflation.

But while many central bankers still believe his dictum, few, including those at the Fed, allow their policy to be guided by a target for money-supply growth. That's because the quantity of money in the economy -- which, depending on the definition, can include currency in circulation, commercial-bank reserves at the central bank, bank deposits and money-market mutual funds -- is hard to measure, and its relationship to overall spending, which tends to drive prices up or down, often shifts.

European central banks acknowledge the data can be tough to decipher. As money-supply growth rates rise, however, the European Central Bank, the Bank of England and Sweden's Riksbank all have cited the data as a factor in their decisions to raise interest rates lately. Several years of low interest rates have fueled a money glut in Europe. That has prompted central bankers to look again at the relationship between the supply of money circulating in the economy and future prices.

The ECB, which sets monetary policy for the 12 nations that share the euro, has kept the monetarist faith throughout, maintaining a target for money growth since the euro's launch in 1999. Hoping to infuse the fledgling currency with credibility, the ECB borrowed a page from the Bundesbank, the German central bank that kept prices steady for several decades before the euro's introduction.

The ECB's president, Jean-Claude Trichet, providing a rare peek at how money-supply numbers affect the bank's decision making, revealed this fall that strong money growth prompted the ECB to start raising rates last December. At the time, other economic signals were mixed and international organizations, such as the International Monetary Fund, advised holding steady. "In retrospect, money turned out to be a good trigger, which put them ahead of the curve," says Thomas Mayer, chief European economist for Deutsche Bank in London.

With economic signals becoming mixed again, money supply could again prove decisive for the euro area. The region's economic growth is expected to slow next year, while a German sales-tax increase in January will likely boost prices and damp consumption, making the region's economic data hard to interpret. Despite a series of interest-rate rises that have taken the ECB's base lending rate to 3.25% from 2% last December, money growth is still going gangbusters in the euro zone: September's rate was 8.5%, nearly double the ECB's 4.5% goal.

Other European central banks don't set explicit money-growth targets. But the Bank of England cited strong money growth as a reason for raising rates in August -- a move that surprised markets. Now, with interest rates at a five-year high of 5%, British monetary-policy makers continue calling attention to the fact that, at 14.5%, annual broad money growth in September was the fastest in 16 years.

Sweden's Riksbank cited August's 19% annual rate of money growth in the minutes of its rate-setting meeting in October, when it voted unanimously to raise key rates a quarter-point to 2.75%. With inflation at 1.3%, well below the central bank's 2% target, some economists say the Riksbank also could use money-supply growth to justify more rapid rate increases going forward. "Money," says Thorsten Polleit, an economist with Barclays Capital in Frankfurt, "is back."

But not in the U.S. Fed Chairman Ben Bernanke told a Frankfurt audience recently that financial innovation and the fact that as much as two-thirds of the U.S. currency is held outside the U.S. means "a heavy reliance on monetary aggregates as a guide to policy would seem to be unwise in the U.S. context." Although Mr. Bernanke says the Fed continues to look at money data, the bank stopped publishing its broadest measure of money supply, the so-called M3, in March. With money-supply growth in the U.S. -- and Japan -- much slower than in Europe, it is also less of an issue. Central bankers in both countries rely more on measures such as inflation, unemployment and gross-domestic-product growth to gauge price pressures.


Some economists say money growth's renewed appeal comes from central bankers' desire to prevent asset price bubbles developing in an era of relatively low consumer-price inflation and hot property markets. Low interest rates and easy money, the thinking goes, can lead to the buildup of bubbles that themselves threaten price stability.

"If you were to target some money supply, then you'd not be encouraging asset-price bubbles like the one we saw in the late 1990s and the one that is currently bursting now, in housing," in the U.S. says Paul Kasriel, chief economist at Northern Trust Co. in Chicago.

Other economists doubt money-growth's value as a predictor of asset bubbles, and point out that money-growth rates have been high in the euro zone and the United Kingdom for several years. If further rate increases are meant to target hot European housing markets, "it's a bit late," says Michael Dicks, chief European economist with Lehman Brothers in London. "They should have done it three years ago, if they really cared about it."

--Greg Ip contributed to this article.

Write to Joellen Perry at joellen.perry@wsj.com1

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