Monetarism remains a useful guide to inflation

Monetarism claims that monetary policy works by the effect of the Federal Reserve’s actions on the money supply. In word and in deed, Federal Reserve officials reject this principle. And a long tradition in macroeconomics, most recently manifested in position paper by Florian Kern, Philippa Siegl-Glöckner and Max Krahe – offers more detailed criticism. This short essay provides the answer by placing the debate between monetarists and their critics in a historical perspective, providing evidence to support the key theses of monetarism, and explaining how monetarist principles can be used to good use to improve monetary policy strategy today.

This is clear: Federal Reserve officials conduct monetary policy by controlling interest rates. In normal times, they adjust their target on the federal funds rate, the interest rate on very short-term loans between banks, in order to achieve their goals of stabilizing inflation and unemployment. During severe recessions, after cutting the interest rate to zero, they change tactics, offering proactive guidance that promises to keep the interest rate lower even after the economy starts to recover, and make large-scale purchases of Treasury bonds and mortgage bonds. securities, all to lower long-term interest rates and thus provide additional political stimulus.

Measures of the money supply such as M2 play absolutely no role in this strategic structure. Federal Reserve Chairman Jerome Powell acknowledged this. In response to a question from Louisiana Senator John F. Kennedy in February 2021he explained:

Well, when you and I studied economics a million years ago, M2 and monetary aggregates seemed to have something to do with economic growth. Right now, I would argue that M2 growth, which is quite substantial, doesn’t really have a major impact on the economic outlook. M2 was removed from the standard list of leading indicators a few years ago, and this classic link between monetary aggregates and the size of an economy no longer holds.

In fact, the “classic relationship” referred to in Chairman Powell’s statement is at the heart of what Karl Brunner, writing in 1968first called “monetarism”.

Brunner lists three main principles of monetarism:

First, money impulses are the main factor explaining fluctuations in output, employment, and prices. Second, money supply movements are the most reliable indicator of the strength of money impulses. Third, the behavior of the monetary authorities dominates the movement of the money supply during business cycles.

Brunner also summarizes a number of classic articles objecting to these monetarist positions:

These articles contain a counter-criticism arguing that money impulses are not properly measured and are not actually conveyed by the money supply. The authors reject the monetarist thesis that money impulses are the main factor determining fluctuations in economic activity and argue that cyclical fluctuations in money supply growth cannot be related to the behavior of the Federal Reserve authorities. It is argued that these fluctuations are primarily the result of the behavior of commercial banks and the population.

New Kern position paper and others. and another recent article Peter Stella skillfully updated the “counter-criticism” in Brunner’s review. On the other hand, recent publications Kenneth Stewart and by John Greenwood & Steve H. Hanke argue for the continued empirical relevance of Brunner’s monetarist proposals. Thus the debate between monetarists and their critics continues more than half a century after the publication of Brunner’s summary—not quite “a million years,” as Chair Power jokingly claims, but a very long time nonetheless!

For monetarists Milton Friedman and Anna Jacobson Schwartz Monetary history of the United States remains the most important source of evidence supporting their views. This book changed economists’ understanding of the Great Depression by highlighting the key role of relentlessly restrictive monetary policy in deepening and prolonging the recession. Moreover, it emphasized that the contractionary stance of monetary policy was reflected not in interest rates, which fell sharply in 1929 and remained low throughout the ensuing decade, but rather in the money supply, which from August 1929 to March 1933 “fell by more than a third … more than three times the largest previous decline recorded in our series.”

Further support for monetarist proposals comes from research on hyperinflation. Philip Kagan for the first time showed an explosive price increase, the pace of which exceeded 50 percent. per month, could be explained by an equally explosive growth in the money supply at rates far exceeding the growth in the demand for money. Meanwhile, as Keith Fylactis and David Blake showed that interest rates rise proportionately in countries with exceptionally high inflation. Again, in this experience, the stance of monetary policy is more accurately reflected in measures of money growth than in interest rates.

The Great Depression and episodes of hyperinflation provide the strongest evidence for monetarist assumptions precisely because they are so extreme. Movements in the money supply become so significant that they overshadow all other factors that can also affect economic growth and inflation, creating natural experiments that reveal the impact of money growth in isolation. in my own recent researchHowever, I have shown that the same statistical relationships between money supply growth, real GDP growth, and inflation that were the focus of Friedman and Schwartz Money history still appear in US data. As a simple illustration, the chart below compares the decadal average growth rates of M2 and inflation over the long period from 1877 to 2021. Inflation is measured by changes in the GDP deflator using annual data from Measurement of value Web site. The long year series for M2 is obtained by pooling post-1959 data from the Federal Reserve Bank of St. Louis. Louis FRED database to pre-1959 data from Table 4.8 by Milton Friedman and Anna J. Schwartz. Monetary trends in the United States and the United Kingdom.

It is easy to see the deflation caused by the contraction of the money supply during the Great Depression. And it is just as easy to see the inflation caused by the excessive growth of the money supply during both world wars, and especially in the 1970s.

The growth spurt in M2, which began in 2020, is also obvious. Looking back in light of inflation since then, Federal Reserve officials made the mistake of ignoring the signal sent by money growth in 2021. However, looking ahead, Monetarist principles can still be put to good use. Historical evidence strongly suggests that if excessive M2 growth is allowed to persist, high inflation will also continue. On the other hand, if the Fed raises interest rates too quickly, a sharp decline in M2 growth will signal the risk of a recession. Monitoring M2 growth can help ensure the Fed is tightening monetary policy at an appropriate pace, neither too fast nor too slow.

Fed officials may not be willing to completely abandon their interest rate management strategy, abandoning their short-term stabilization goals by adopting the permanent money supply rule that is best known Milton Friedman. But they should certainly revisit the “classical relationship” between money and the economy that the monetarists discovered long ago.

Peter N. Ireland

Peter N. Ireland is the Murray and Monty Professor in the Department of Economics at the Morrissey College of Arts and Sciences at Boston College and a member of the Shadow Open Market committee.

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