Money Supply Growth Rate Targeting Explained

A money supply growth rate target is a central bank’s commitment to expand the M1 or M2 money aggregate at a fixed annual rate—typically 2% to 6%—to anchor inflation expectations and smooth economic cycles. The Federal Reserve and other central banks used this framework heavily from the 1970s to 1990s, but abandoned it as financial innovation rendered money definitions unreliable and forward guidance proved more effective.

The Monetarist Case for Money Growth Rules

In the 1970s, Western economies were trapped in stagflation: high inflation and high unemployment simultaneously. Traditional Keynesian fiscal policy seemed powerless. Economist Milton Friedman and his followers argued the real culprit was monetary excess—central banks printing money too fast, causing inflation while creating boom-bust cycles.

Friedman proposed a radical simplification: the central bank should announce a fixed annual growth rate for the money supply and stick to it, regardless of economic conditions. If the central bank committed to, say, 4% annual M2 growth, inflation would stabilize near 4%, growth would be steady, and markets would no longer fear monetary shocks.

The logic was appealing. Monetary policy would become predictable and rule-based, eliminating discretionary errors and political pressure. Markets could plan further ahead. Inflation wouldn’t surprise. Central bankers would no longer overreact to each quarter’s economic data, fueling boom-bust cycles.

This framework was called a k-percent rule after Friedman’s proposed constant-growth target. It represented a fundamental shift from discretion (adjust monetary policy each meeting based on conditions) to rules (commit to a mechanical formula).

Adoption by Central Banks: 1970s–1980s

The Federal Reserve under Chairman Paul Volcker embraced a version of this approach starting in 1979. Facing runaway inflation (over 13% by 1980), Volcker announced explicit M1 growth targets—aiming to shrink the growth rate over several years to combat inflation. The message was clear: the Fed would reduce money growth and accept a painful recession if necessary to break the back of inflationary expectations.

Volcker’s approach worked. By anchoring expectations to a declining M1 target, inflation fell from 13% in 1980 to 3% by 1985. The cost was the deep 1981–82 recession, but it proved that committing to money growth rules could break entrenched inflation.

Other central banks followed. The Bank of England, the Bundesbank (now part of the European Central Bank), and others announced M1 and M2 growth targets. Through the 1980s and early 1990s, money supply targeting was mainstream monetary policy.

The Problem: What Is “Money”?

As the 1980s and 1990s progressed, the link between money growth and inflation loosened. Central banks announced M2 growth targets of 3–6%, but inflation didn’t follow the predicted path. Sometimes M2 growth accelerated without lifting inflation. Other times inflation rose even as money growth slowed.

The culprit was financial innovation. Money traditionally meant cash and checking deposits—the most liquid stores of value. But starting in the 1970s, banks created money-like instruments: money-market mutual funds, NOW accounts (interest-bearing checking accounts), and other near-money products. These felt like money to households and businesses, but the Federal Reserve couldn’t control their supply directly.

More fundamentally, the relationship between the quantity of money and the price level depends on the velocity of money—how fast money turns over in the economy. If velocity is constant, doubling M2 doubles prices. But velocity proved unstable. In recessions, people hoard money instead of spending it, so velocity falls and inflation doesn’t spike despite higher M2 growth. In booms, velocity rises, and inflation can spike even with stable money growth.

Each financial innovation—credit cards, securitization, derivatives—further decoupled the money aggregates that central banks could measure from the actual liquidity and spending power circulating in the economy. By the 1990s, targeting a specific M2 growth rate felt like aiming at a moving target that itself was changing shape.

The Credit Channel Problem

A second issue emerged: money growth targets ignored the credit cycle. In the late 1980s, the Federal Reserve was holding M2 growth in the target range, but credit was exploding—banks were making massive real estate loans, inflating an asset bubble.

The central bank had hit its money target, but inflation and asset prices were accelerating anyway. Money growth alone couldn’t tell the full story. A household borrowing $400,000 against an inflated house had enormous spending power, even if the M2 growth rate was “correct.” Ignoring credit creation left central banks blind.

Similarly, when the savings and loan crisis hit in 1990–91, credit suddenly contracted even as the Federal Reserve tried to expand the money supply. The central bank could announce M2 targets, but if banks weren’t lending and households were deleveraging, those targets wouldn’t translate into spending.

Shift to Federal Funds Rate Targeting

By the mid-1990s, the Federal Reserve quietly stopped announcing explicit money growth targets. Instead, it shifted focus to the federal funds rate—the overnight interest rate that banks charge each other.

Interest rate targeting was more flexible. The Fed could observe the funds rate and adjust it in response to real-time economic data. Inflation, unemployment, and growth could all be considered. And unlike money growth targets, the funds rate was a variable the Fed could control directly through open-market operations.

Under Federal Reserve Chair Alan Greenspan and his successors, the Fed announced target ranges for the federal funds rate, then adjusted those targets based on incoming economic data. This was closer to discretionary monetary policy than the rules-based k-percent rule, but it proved more effective in a world of financial innovation.

Why Some Countries Kept Money Targets Longer

A few central banks, notably the European Central Bank (formed in 1999), retained explicit money growth targets as a “pillar” of policy, alongside other indicators. The ECB announced a reference value for M3 growth of 4.5% per year. But even the ECB treated this as one input among many, not a binding rule. The target was a helpful anchor for expectations, but miss it if economic conditions demanded.

Over time, even these nominal targets became less prominent. Central banks recognized that targeting a monetary aggregate was useful for signaling commitment to price stability, but the actual mechanism—the instrument—was better left flexible.

Modern Policy and the Legacy of Money Targeting

Today, monetary policy frameworks rely on forward guidance, interest rate targets, and quantitative easing rather than money growth rules. Central banks announce expected future interest rates and, when rates hit zero, buy bonds to inject liquidity.

Yet money growth targeting left a legacy. It demonstrated that credible commitment to a monetary rule could break inflation. It also showed why rules need flexibility: when the economic environment changes (innovation, globalization, financialization), a rigid rule becomes counterproductive.

The Federal Reserve under Chair Jerome Powell still monitors M2 growth and publishes the data, but not as a policy target. The aggregates are useful diagnostics—signaling how much liquidity is in the economy—but money growth is no longer the Fed’s primary lever or goal.

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