Fed kills a key inflation gauge

Trend: The Fed kills M3, another statistic that provides insight into inflation. (The core rate CPI was changed to exclude food and energy in 1996.) Skeptics have more ammo for questioning long-term economic policy making.

Jim Jubak at MSN Investing discusses the end of tracking M3, a boring and abstract topic but potentially important measure of money supply and inflation.

Source: MSN Money - Fed kills a key inflation gauge - Jubak's Journal

The U.S. Federal Reserve made big news at the end of March. And almost nobody noticed. Here's the headline you didn't see:

Fed kills M3, decides money supply doesn't count
Move raises risk of higher long-term inflation and new asset bubble

The Federal Reserve conspiracy theorists go on to argue that this is exactly the kind of monetary policy you'd expect from the world's greatest debtor nation. Use your credentials as a short-term inflation fighter to convince global savers it's safe to buy U.S. dollars and U.S. debt, while at the same time supporting the long-term inflation that will cut the future value of that debt and thus let the U.S. pay back its current debt in less-valuable future dollars.

Of course, I'd never want to go so far as to put something like that in print. It's just too outlandish to believe.

So instead, let me offer up a more concrete fear. Although the Federal Reserve may be correct when it argues that there isn't a tight connection between inflation and growth in the money supply over the short-run, the data does argue, convincingly in my opinion, for a connection in the long run.

This monetarist view of the link between growth in the money supply and growth in inflation was once part of mainstream thinking at the U.S. Federal Reserve. The great monetarist economist Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon." That view was echoed in policy at the U.S. Fed when then-chairman Paul Volcker starved the inflation of the late 1970s by tightening the money supply.

But the Fed -- under Greenspan, and so far under Bernanke -- has behaved as if money supply growth didn't matter and as if price inflation were all that mattered. Even as they have raised interest rates in an effort to slow the economy and reduce demand, they've continued to let money supply grow at close to double-digit rates. M3, the most inclusive measure of the money supply, grew at a seasonally adjusted annual rate of 8.7% in the three months from November 2005 to February 2006. That's faster than the annual rate -- 8% -- for the 12-month period beginning in February 2005.

So if you want to fully understand the Federal Reserve -- and where this most-powerful U.S. economic institution is taking the national and global economy -- don't just look at the headlines touting the Fed as inflation fighter. Higher interest rates are half the story. And the near-term half, at that.

Because, even as the Federal Reserve is raising the cost of money for consumers and home buyers, it's keeping the money supply spigots wide open.

In the long run, countries with faster-growing money supplies experience higher inflation.

And even worse, if the money supply grows fast enough, it provides the liquidity required for the runaway growth of asset bubbles, like the stock market in 2000. And, some would argue, like the U.S. real-estate or credit markets now.

In the long run, that's likely to be more important to you than the next quarter-point hike in interest rates.