Misleading propositions & rules
can easily lead to bad monetary policy and "nasty" outcomes
One thing that bugs me is the “proposition” (or meme) that “inflation results from too much money chasing too few goods”. Or, in its “Oxford English” extended version:
The key propositions of the modern quantity theory were that: based on the interaction between a stable long run demand for money [or stable velocity] and an independently determined money supply, a change in the rate of growth in the money supply [or change in the rate of growth of money per unit of output] would produce a corresponding but lagged change in the growth of nominal income.
The link above is to Michael Bordo and Hugh Rockoff´s 2013 paper “Not just the Great Contraction: Friedman and Schwartz´s A Monetary History of the United States 1867 to 1960”, prepared for the Session “The Fiftieth Anniversary of Milton Friedman and Anna J Schwartz, A Monetary History of the United States (AMH), AEA Annual Meetings, January 6 2013.”
In their overview of the evidence, the first example comes from the last quarter of the 18th Century:
From 1879 until 1896, the money supply grew relatively slowly producing a mild deflation.
But later they write:
Research by Bordo and Filardo (2004) and Bordo, Landon-Lane, and Redish (2008) looked back to the discussion in AMH chapter 3 on the deflation of 1879-1896. In that episode classified as Good Deflation, the price decline reflected a positive aggregate supply shift reflecting rapid productivity growth [from railroads & electricity].
The chart illustrates the well known result that in the face of a productivity (positive supply) shock, if aggregate nominal spending (NGDP) growth remains stable, real output will increase and prices (or inflation) will fall.
However, many associate a fall in prices (or deflation) with “depression”. According to Wikipedia:
The Long Depression was a worldwide economic recession, that began in 1873 and ended around 1896.
The “Achilles Heal” of the Quantity Theory (QT) is the assumption of a stable velocity. As I´ll show later with the example of 2020, velocity is stable until it isn´t! It is at those times that the Fed has to show its “mettle”. In the 18th C, however, there was no central bank. Nevertheless, the system managed to closely offset changes in velocity with changes in money supply, thus keeping NGDP growth relatively stable, allowing prices to fall to “accommodate” the productivity shock.
The chart illustrates.
The other staple of the QT are the “long and variable lags”:
…a change in the rate of growth in the money supply [or change in the rate of growth of money per unit of output] would produce a corresponding but lagged change in the growth of nominal income.
We just don´t see any “lagged” change in the growth of NGDP in the chart above (and this will be confirmed in other instances examined later). As soon as money growth does not adequately offset changes in velocity, NGDP growth changes!
Another example of the evidence from Bordo & Rockoff is the two World Wars:
During World War I, the Fed became subservient to the Treasury, buying debt in order to keep nominal interest rates low and stable. The same was true in World War II, and the two wars together became further grist for the mill. Inflation proceeded at a somewhat slower pace in World War II than in World War I.
Yet World War II was by many measures the more intense conflict: the period of active engagement was longer, the casualty rate was higher, and federal deficits were larger relative to GDP. Part of the difference between the wars was that money per unit of output grew more slowly in World War II than in World War I
That is, however, contradicted by the evidence. In WWII money per unit of output rose almost continuously while inflation fell!
However, if instead of looking at the question from the perspective of “money per unit of output” you look at it from the perspective of a “thermostat”, where money is the “control variable” which has to be set so as to offset changes in velocity in order to keep NGDP on a stable growth path, the different outcomes for inflation in the two World Wars become clear.
During WWI, instead of offsetting changes in velocity, money supply “enhanced” them, imparting an upward trend to NGDP growth and inflation. During WWII, a higher average money growth was insufficient to offset the fall in velocity that occurred, resulting in a down-trending NGDP growth and inflation. Note that there are no lags between changes in money growth relative to changes in velocity and changes in NGDP growth and inflation!
At another point in the paper, B&R go “off script”, appealing to the Taylor Rule:
The Fed in 2002-2006 followed a very expansionary monetary policy based on negative deviations of its policy rate from the Taylor Rule (Taylor 2007). It did this because of the fear of the then very low inflation rate spiraling into a 1930s type debt deflation or a Japan in the 1990s style stagnation
The story is told in the charts below. Note how the 90/91 and 2001 recessions were due to a “malfunctioning of the thermostat”, when money growth did not adequately offset changes in velocity, leading to a drop in NGDP (and RGDP) growth. After the 2001 recession, the Fed did a good job of getting NGDP back on the trend path. If, as argued, monetary policy “ignored” the Taylor Rule but achieved nominal stability, it just shows that the “TR” is just as misleading as the “Money per unit of output” indicator!
B&R´s paper does not include in its “evidentiary narratives” the Pandemic period of 2020-22. However, the QT propositions are present in the latest e-mail from the Institute of International Monetary Research (IIMR) spearheaded by the well known British monetarist Tim Congdon from which I quote:
It may seem obvious now that, when speaking on 14th April 2021, Clarida ought to have known about the money growth figures and realized that something was wrong.
Given how badly the Fed had blundered, he should not have made the artless and inept remarks about anchoring “longer-term inflation expectations” at 2%. Within a few quarters, inflation would soar far above 2%.
My worries in spring 2020 were based on the clear similarity over the medium and long runs of the growth rates of M3 broad money and nominal GDP. This similarity seemed to me to accord with the underlying stability of money-holding preferences which is crucial to the quantity theory of money, or “monetarism” as the key ideas have been widely labelled since the 1970s.
It is important to show where the economy was at before the pandemic hit (for more details, see here). For the 10 years following the Great Recession, the “thermostat” was working quite well, with the Fed closely offsetting variations in velocity thus keeping NGDP growing along a stable path. RGDP growth stability, low and stable inflation and downtrending unemployment were the result. (note: this is monthly data)
The pandemic was a “special” type of shock. It simultaneously blocked production and demand (from lockdowns, for example). It had an additional demand component from the sudden and deep fall in velocity.
The Fed´s reaction was quick & “massive” but not quick (or “massive”) enough to avoid NGDP dive growth into negative territory. (Note: It´s funny to see monetarists complain about the record rise in money supply at the time, immediately focusing on its inflationary effect down the road, when it was exactly what was needed. Just imagine how far NGDP & RGDP would have fallen otherwise!).
Velocity, which was quite stable during the previous 10 years, suddenly saw the “floor open up below it”.
Having shown the start of the pandemic and its impacts, I believe it´s preferable to illustrate the recent story with level charts. It will make it easier to connect the dots.
By “connecting the dots”, I mean being able to provide a breakdown of inflation, clearly see where the Fed did right and erred, and suggest the way forward. I have previously presented this chart, but will do so again because I believe its didactic.
Once again it should be noted that the Fed did right in trying to bring NGDP back to trend as quickly as possible, so let´s concentrate on the period marked by the colored bars.
We observe that some measures of inflation rose when NGDP reached the post GR trend path. Imagine that was our starting period. Imagine also that at that point RGDP was also on its trend path. We know (or should) by now, understand that a supply shock will decrease output and increase inflation. The changes in output and inflation will be “optimal” if NGDP stays on trend.
Note that´s exactly what happened during the period delimited by the gray bar. So all the inflation during that period can be imputed to the supply shock that at that point became binding.
The supply shock related to the pandemic is much more than the traditional oil shock, but its impact on inflation is not “general” because the trimmed mean PCE (call it “super core) does not rise.
So, up to July 2021, the Fed got an A for its performance. Maybe “success” went up to its head and that´s when things can go wrong. And they did, with the Fed increasing NGDP above its trend path.
During the period defined by the green bar, then, inflation is driven mostly by demand. It also becomes “general”, with “super core” prices going up. With RGDP going to trend, we can say the economy was (given the supply constraints) “running hot”.
After October 2021 (blue bar), the Fed tapers its enthusiasm somewhat. With that, the economy “cools down” a bit, with RGDP (reflecting supply constraints) falling below trend and inflation “decelerating”, with indications it may begin to come down!
The Fed´s challenge going forward remains the same: “calibrate the thermostat to bring NGDP back to the trend path”. The least painful way to achieve that goal is to keep the level of NGDP as constant as possible until actual NGDP “meets the trend level of NGDP down the road”. That´s not an easy task, mostly due to the somewhat erratic behavior of velocity reflecting lingering effects of the pandemic and the war in Ukraine.
One thing I´m sure of is that that goal will not be met pushing hard on interest rates or, as Tim Congdon writes in his email: “that in trying to bring inflation down, central banks may cause money growth to crash.”