How well historically has the Fed performed against a 2% inflation target?

Late last month the Federal Reserve made a clear assertion of its inflation target:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. [Source]

Milton Friedman, 1976 Economics Nobel Prize winner, immortalized the assertion that "Inflation is always and everywhere a monetary phenomenon." The concept is simple: An increase in money supply constitutes inflation, and a decrease in money supply constitutes deflation. At the simplest level, we can assume that an increase in the money supply may result in an increase in consumer prices.

The measures of pure monetary growth are M1, M2, MZM and the discontinued M3 (with some extrapolation), which are available at FRED, the Federal Reserve Economic Data repository hosted by the St. Louis Fed. A close examination of some monetary growth charts will provide more insight on the trajectory of money supply.

First, let's review a table showing the constituents of money supply. The categories listed here help us answer the grand question, "How much money is out there?"

Readers should understand the Federal Reserve's dual mandate of price stability and maximum employment and remember that the mandate applies to the "Long Run." Mathematically, an inflation target of 2% annually produces a purchasing power of $452.89 in 40 years using $1,000 as present value. Call me crazy, but a targeted 60% reduction in purchasing power during a worker's career seems outside the mandate of "long run price stability." While this quick math example seems random, we must also remember that the Chairman of the Federal Reserve, Ben Bernanke, specifically targeted 2% annually as acceptable.

The Fed actually uses the Bureau of Economic Analysis (BEA) core Personal Consumption Expenditures (core PCE), which basically excludes the higher volatile data for food and energy prices. PCE has generally been lower than the Consumer Price Index (CPI) over the long haul (more on that topic here).

Using the 2% target, let's have some fun with numbers and try to determine how effective the Federal Reserve has been based on money supply measures rather than CPI or PCE. If we use Milton Friedman's inflation definition, we should measure the actual increase or decrease in the money supply. The more familiar CPI is commonly thought of in year-over-year comparisons, but if we truly care about the long run, let's explore how several measures of money supply grew on a compounded annual growth rate (CAGR) over various time periods. Specifically, the following charts use 5, 10, 15, and 20 year compounded annual growth rates since 1959. The first chart is based on data available from FRED and shows the M1 money supply measure. The yellow line highlights the inflation target of 2%.

 

 

As of November 11, the 5 year growth rate of M1 has accelerated to 7% annually with M1 sitting just a shade over 2 Trillion. Hopefully that doesn't concern anyone actually using dollars to purchase goods. To measure how many years M1 fell below 2%, the table below shows the performance for each time period. The table simply counts the number of occurrences below 2% and shows the number of measurements, the number below 2%, and percent above.

Actually, the Fed's ability to control long run price stability over 20 years is the best. From 1959 to present, the Fed achieved an annual target of 2% only 3 times (the first three years) for a stellar success rate of less than 10%. The Fed basically missed the 2% "target" 90% of the time. Not very impressive results. Of course the earlier years in our timeframe were skewed by the decade of stagflation from the early 1970s to the early 1980s.

Let's move to another measure of money supply, M2. Again, the chart below displays the growth of M2 over comparative time periods similar to the M1 chart (5, 10, 15, and 20 year). Again, our target of 2% highlighted in yellow.

 

 

While M2 rests at 9.2 Trillion, the success rate of long run price stability measured against the respective time periods achieves a brilliant near 100% perfection (of never reaching the "target").

From all the measurements, the FED scored a near perfect as only 1 occurrence was below 2%. Stunning.

Our almost-last chart reflects Money at Zero Maturity. MZM ends 2011 around 10.5 Trillion (from 281 Billion in 1959).

 

 

Note how MZM never comes close to the 2% line. For this money supply measure, the FED achieves a 100% score card (or zero percent accuracy).

M3, a favorite measure of monetary growth for many Fed watchers, was discontinued in 2006, it can be reconstructed. Although not official, the following chart shows the actual M3 until 2006 with extrapolated data after that (highlighted area).

 

 

Again, the FED performs admirably and scores a near perfect failure rate as 3 times M3 fell below 2%.

With this analysis, inspired by Milton Friedman's assertion that inflation is a monetary phenomenon, we can clearly see that monetary growth from each of these measures has consistently been well above the 2% "target." Perhaps these charts provide a better understanding of just how successful the Fed has been concerning monetary policy over the "long run." Perhaps an understanding the rapid growth of money during the last 50 years also helps explain why final prices have increased -- quite independently from the official BLS measurement of consumer inflation.