Monetarists have long argued that there is a strong relationship
between money supply and the growth in gross domestic product (GDP).
Starting in the late 1970s, the relationship between money supply
and GDP growth became more volatile because of changes in U.S. financial
markets. The increase in importance of stock and bond mutual funds
and the decrease in certificates of deposit and savings accounts
in a consumer's portfolio had a significant impact on measures of
the money supply. Stock and bond mutual funds are not included in
any of the measures of money. Prior to the late 1970s, the Fed used
to announce target levels of money growth and the Fed's performance
was graded by comparing actual money growth with the targets. The
now muddied relationship between money and growth has caused the
Fed to announce their monetary objectives in benchmark ranges rather
than as a specific target.
The Fed had listed benchmark growth in M2, a measure of the amount
of money, to be between 1% and 5% for 1997. Actual growth in M2,
however, was above the 5% range. Furthermore, M2 growth has stayed
above 5% in 1998 even though the Fed has advertised the same benchmark.
The growth in M2 above the upper benchmark has caused some groups
to argue for interest rate hikes to prevent a rekindling of inflation.
The Fed in its defense argues that the efficacy of using a single
monetary aggregate like M2 to guide policy is a mistake. The Fed's
rationale is that the link between money and GDP growth--the velocity
of money--is unstable.
While some Fed officials make note of the growth of M2, the majority
set policy based on a number of economic variables. Included in
this list is current dollar GDP. If the growth in current dollar
GDP doesn't slow, interest rates may have to increase. (Updated
May 19, 1998)