Why the Fed buried mon­e­tarism

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The US Fed­eral Re­serve’s de­ci­sion to de­lay an in­crease in in­ter­est rates should have come as no sur­prise to any­one who has been pay­ing at­ten­tion to Fed Chair Janet Yellen’s com­ments. The Fed’s de­ci­sion merely con­firmed that it is not in­dif­fer­ent to in­ter­na­tional fi­nan­cial stress, and that its risk-man­age­ment ap­proach re­mains strongly bi­ased in fa­vor of “lower for longer.” So why did the mar­kets and media be­have as if the Fed’s ac­tion (or, more pre­cisely, in­ac­tion) was un­ex­pected?

What re­ally shocked the mar­kets was not the Fed’s de­ci­sion to main­tain zero in­ter­est rates for a few more months, but the state­ment that ac­com­pa­nied it. The Fed re­vealed that it was en­tirely un­con­cerned about the risks of higher in­fla­tion and was ea­ger to push un­em­ploy­ment be­low what most econ­o­mists re­gard as its “nat­u­ral” rate of around 5%.

It is this re­la­tion­ship – be­tween in­fla­tion and un­em­ploy­ment – that lies at the heart of all con­tro­ver­sies about mon­e­tary pol­icy and cen­tral bank­ing. And al­most all mod­ern eco­nomic mod­els, in­clud­ing those used by the Fed, are based on the mon­e­tarist the­ory of in­ter­est rates pi­o­neered by Milton Fried­man in his 1967 pres­i­den­tial ad­dress to the Amer­i­can Eco­nomic As­so­ci­a­tion.

Fried­man’s the­ory as­serted that in­fla­tion would au­to­mat­i­cally ac­cel­er­ate with­out limit once un­em­ploy­ment fell be­low a min­i­mum safe level, which he de­scribed as the “nat­u­ral” un­em­ploy­ment rate. In Fried­man’s orig­i­nal work, the nat­u­ral un­em­ploy­ment rate was a purely the­o­ret­i­cal con­jec­ture, founded on an as­sump­tion de­scribed as “ra­tio­nal ex­pec­ta­tions,” even though it ran counter to any nor­mal def­i­ni­tion of ra­tio­nal be­hav­iour.

The the­ory’s

pub­li­ca­tion

at

a

time

of world­wide alarm about dou­ble-digit in­fla­tion of­fered cen­tral bankers ex­actly the pre­text they needed for des­per­ately un­pop­u­lar ac­tions. By dra­mat­i­cally in­creas­ing in­ter­est rates to fight in­fla­tion, pol­i­cy­mak­ers broke the power of or­gan­ised labour, while avoid­ing blame for the mass un­em­ploy­ment that mon­e­tary aus­ter­ity was bound to pro­duce.

A few years later, Fried­man’s “nat­u­ral” rate was re­placed with the less value-laden and more eru­dite-sound­ing “nonac­cel­er­at­ing in­fla­tion rate of un­em­ploy­ment” (NAIRU). But the ba­sic idea was al­ways the same. If mon­e­tary pol­icy is used to try to push un­em­ploy­ment be­low some pre­de­ter­mined level, in­fla­tion will ac­cel­er­ate with­out limit and de­stroy jobs.

A mon­e­tary pol­icy aim­ing for sub-NAIRU un­em­ploy­ment must there­fore be avoided at all costs.

A more ex­treme ver­sion of the the­ory as­serts that there is no last­ing trade­off be­tween in­fla­tion and un­em­ploy­ment. All ef­forts to stim­u­late job cre­ation or eco­nomic growth with easy money will merely boost price growth, off­set­ting any ef­fect on un­em­ploy­ment.

Mon­e­tary pol­icy must there­fore fo­cus solely on hit­ting in­fla­tion tar­gets, and cen­tral bankers should be ex­on­er­ated of any blame for un­em­ploy­ment.

The mon­e­tarist the­ory that jus­ti­fied nar­row­ing cen­tral banks’ re­spon­si­bil­i­ties to in­fla­tion tar­get­ing had very lit­tle em­pir­i­cal back­ing when Fried­man pro­posed it. Since then, it has been re­futed both by po­lit­i­cal ex­pe­ri­ence and sta­tis­ti­cal test­ing. Mon­e­tary pol­icy, far from be­ing dis­si­pated in ris­ing prices, as the the­ory pre­dicted, turned out to have a much greater im­pact on un­em­ploy­ment than on in­fla­tion, es­pe­cially in the past 20 years.

But, de­spite em­pir­i­cal refu­ta­tion, the ide­o­log­i­cal at­trac­tive­ness of mon­e­tarism, sup­ported by the sup­posed au­thor­ity of “ra­tio­nal” ex­pec­ta­tions, proved over­whelm­ing. As a re­sult, the purely in­fla­tion-ori­ented ap­proach to mon­e­tary pol­icy gained to­tal dom­i­nance in both cen­tral bank­ing and aca­demic eco­nom­ics.

That brings us back to re­cent fi­nan­cial events. The in­fla­tion-tar­get­ing mod­els used by the Fed (and other cen­tral banks and of­fi­cial in­sti­tu­tions like the In­ter­na­tional Mon­e­tary Fund) all as­sume the ex­is­tence of some pre-de­ter­mined limit to non­in­fla­tion­ary un­em­ploy­ment. The Fed’s latest model es­ti­mates this NAIRU to be 4.9-5.2%.

And that is why so many econ­o­mists and mar­ket par­tic­i­pants were shocked by Yellen’s ap­par­ent com­pla­cency. With US un­em­ploy­ment now at 5.1%, stan­dard mon­e­tary the­ory dic­tates that in­ter­est rates must be raised ur­gently. Oth­er­wise, ei­ther a dis­as­trous in­fla­tion­ary blowout will in­evitably fol­low, or the body of eco­nomic the­ory that has dom­i­nated a gen­er­a­tion of pol­icy and aca­demic think­ing since Fried­man’s pa­per on “ra­tio­nal” ex­pec­ta­tions and “nat­u­ral” un­em­ploy­ment will turn out to be com­pletely wrong.

What, then, should we con­clude from the Fed’s de­ci­sion not to raise in­ter­est rates? One pos­si­ble con­clu­sion is ba­nal. Be­cause the NAIRU is a purely the­o­ret­i­cal con­struct, the Fed’s econ­o­mists can sim­ply change their es­ti­mates of this magic num­ber. In fact, the Fed has al­ready cut its NAIRU es­ti­mate three times in the past two years.

But there may be a deeper rea­son for the Fed’s for­bear­ance. To judge by Yellen’s re­cent speeches, the Fed may no longer be­lieve in any ver­sion of the “nat­u­ral” un­em­ploy­ment rate. Fried­man’s as­sump­tions of ever-ac­cel­er­at­ing in­fla­tion and ir­ra­tionally “ra­tio­nal” ex­pec­ta­tions that lead to sin­gle-minded tar­get­ing of price sta­bil­ity re­main em­bed­ded in of­fi­cial eco­nomic mod­els like some Bib­li­cal cre­ation myth. But the Fed, along with al­most all other cen­tral banks, ap­pears to have lost faith in that story.

In­stead, cen­tral bankers now seem to be im­plic­itly (and per­haps even un­con­sciously) re­turn­ing to pre­mon­e­tarist views: trade­offs be­tween in­fla­tion and un­em­ploy­ment are real and can last for many years. Mon­e­tary pol­icy should grad­u­ally re­cal­i­brate the bal­ance be­tween these two eco­nomic in­di­ca­tors as the busi­ness cy­cle pro­ceeds. When in­fla­tion is low, the top pri­or­ity should be to re­duce un­em­ploy­ment to the low­est pos­si­ble level; and there is no com­pelling rea­son for mon­e­tary pol­icy to re­strain job cre­ation or GDP growth un­til ex­ces­sive in­fla­tion be­comes an im­mi­nent dan­ger.

This does not im­ply per­ma­nent near-zero US in­ter­est rates. The Fed will al­most cer­tainly start rais­ing rates in De­cem­ber, but mon­e­tary tight­en­ing will be much slower than in pre­vi­ous eco­nomic cy­cles, and it will be mo­ti­vated by con­cerns about fi­nan­cial sta­bil­ity, not in­fla­tion. As a re­sult, fears – bor­der­ing on panic in some emerg­ing mar­kets – about the im­pact of Fed tight­en­ing on global eco­nomic con­di­tions will prob­a­bly prove un­jus­ti­fied.

The bad news is that the vast ma­jor­ity of mar­ket an­a­lysts, still cling­ing to the old mon­e­tarist frame­work, will ac­cuse the Fed of “fall­ing be­hind the curve” by let­ting US un­em­ploy­ment de­cline too far and fail­ing to an­tic­i­pate the threat of ris­ing in­fla­tion. The Fed should sim­ply ig­nore such atavis­tic protests, as it rightly did last week.

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