Pain: the name of the game

much like the cure-all "bloodleting" in the middle-ages

Joey Politano writes:

The message from the Fed is clear: they believe demand must be contained to fight inflation, and that containing demand will require real economic pain.

“And if we want to set ourselves up—really light the way—to another(!) period of a very strong labor market, we have got to get inflation behind us. I wish there were a painless way to do that, there isn't.”

Jerome Powell, September FOMC Meeting Q&A

Setting the stage

The “instrument” of pain” is interest rates, over which the Fed is thought of exerting control (or at least influence). However, 10 years ago Daniel Thornton of the St Louis Fed wrote “Monetary Policy: Why money matters and interest rates don´t.”

From the introduction:

Today “monetary policy” should be more aptly named “interest rate policy” because policymakers pay virtually no attention to money.

Prominent monetary/macroeconomic economists such as Woodford (2000, 2003, and 2008), Friedman (1999) and King (1999) have suggested the possibility of a moneyless economy: (Benjamin) Friedman and King argue that the absence of money would severely limit the effectiveness of monetary policy; Woodford argues that it would not.

In a similar vein, Svensson (2008) suggests that over the past 50 years monetary theorists and policymakers have learned that “monetary aggregates matter little, or even not at all, for monetary policy.”

Given the prominence of these economists and the lack of interest in money by central bankers around the world, one might think it foolish to assert that money is essential for economic activity and monetary policy.

It will no doubt seem even more foolish to suggest that monetary policymakers’ ability to influence interest rates, especially those that matter for the efficacy of monetary policy, is greatly exaggerated.

I must mention there is a small group of economists that think only money matters. One such monetarist is Steve Hanke from John Hopkins. In a recent interview to Fortune, he says:

It was the M2 blowout that saddled the U.S. with 8%-plus inflation. By Hanke’s estimate, three trillion in excess dollars are still sloshing around in the monetary bathtub, the overage that will spill forth to keep the price level elevated into 2024.

But in the last six months, he says, money supply growth has collapsed from double-digits to zero.

The net effect of the QT launch and slowdown in borrowing sent M2 from explosive expansion to a standstill in a sudden, jarring downshift. For Hanke, a policy that takes M2 growth to zero spells disaster. One of the Fed’s mistakes, he insists, is relying too heavily on interest rates to tame inflation.

There´s much that is wrong in the quote from Hanke. One, about which I´ll have more to say later, is that he never mentions money demand, putting all the “burden” on money supply. Also, unfortunately, his money supply measure is deficient. That is surprising because he is a CFS special counsellor, where CFS is the Center for Financial Stability, which publishes the Divisia Monetary Indices, including Divisia M4, the broadest monetary aggregate.

William A Barnett of the University of Kansas is a CFS Director and was staff member of the Federal Reserve Board from 1974 to 1982 was instrumental in developing Divisia Monetary Indices, and they are described in detail in his book “Getting it Wrong - How faulty monetary statistics undermine the Fed, the financial system, and the economy”.

The chart below clearly shows that (Simple Sum)M2 and Divisia M4 can behave quite differently. While Divisia M4 growth increased up by more and more quickly than M2, it also came down by more and quite a bit faster than M2. (Hanke saying that M2 growth has collapsed from double digits to zero is an exaggeration!)

To appreciate the importance of constructing “robust” monetary aggregates, on page 44 of Barnett´s book we read this quote from Milton Friedman´s and Anna Schwartz´s 1970 book “Monetary Statistics of the United States: Estimates, Sources, Methods, and Data”:

This [simple summation] procedure is a very special case of the more general approach. In brief, the general approach consists of regarding each asset as a joint product having different degrees of “moneyness”, and defining the quantity of money as the weighted sum of the aggregated value of all assets, the weights for individual assets varying from zero to unity with a weight of unity assigned to that asset or assets regarded as having the largest quantity of “moneyness” per dollar of aggregate value. The procedure we have followed implies that all weights are either zero or unity.

The more general approach has been suggested frequently but experimented with only occasionally. We conjecture that this approach deserves and will get much more attention than it has so far received.

Some Evidence

In 2008, the US experienced what came to be called a “Great Recession”. Everything from “greed” to “stupidity” has been blamed for it. In contrast, the Fed´s monetary policy has been called “the savior”, for having avoided a second “Great Depression”!

That´s just not true. From the equation of exchange, MV=Py, in order for the Fed to maintain Nominal Stability (Py) (or stability of aggregate nominal spending or NGDP), and not just Price Stability, the Fed has to change M (money supply) to offset changes in V (velocity (the inverse of money demand)). According to Friedman, that´s how a good “thermostat” works!

The set of pictures below clearly show that was not the case. When velocity fell (green bar), money supply did not increase above trend to offset the fall in velocity. With that, NGDP dropped below trend (as did RGDP, which had already been negatively impacted by the oil shock of 2006-08).

And when velocity climbed back to its stable level (orange bar), money supply fell, after which it climbed steadily along a lower path, thus “condemning” the economy to remain “depressed”! That means, and is clearly seen in the charts, that there was no recovery, just a tacit acceptance of a lower level of output “forever”, which came to be called “new normal” or “secular stagnation”.

From looking at what was happening to interest rates, you wouldn´t conclude that monetary policy was first tightening and than tight (even with interest rates near zero!

People like Steve Hanke, who look at M2 growth, would never conclude that monetary policy was extremely tight!

The Present

The Pandemic that hit the world in early 2020, was a “multifaceted” shock, being simultaneously both a demand and supply shock. The demand shock flowed from an abrupt and deep fall in velocity, which initially overwhelmed the supply shock from lockdowns, supply chain disruptions, etc.

The charts below have the same structure as those displayed above for the Great Recession. I include the pre Great Recession trend as a reference of how far the economy had sunk following the Fed´s very bad monetary policy.

Note the sudden and deep fall in velocity (Green band). Different from what happened in 2008, money supply reacted quickly, making the recession the shortest on record (2 months).

Along the orange band (April 2020 to March 21), velocity rises and money supply rises very slowly. This combination determines the increase observed in NGDP (and RGDP).

As observed in the inflation chart below, the PCE core measure of inflation dropped significantly when NGDP tanked in the initial (green) phase (although the trimmed mean version remained stable. (For those interested, the Dallas Fed has an article on the trimmed mean PCE and compares it with the headline & core PCE) ). During the recovery phase (orange) inflation on both measures remained low and stable. That implies that supply constraints were not binding.

By March 2021, NGDP had climbed back to trend. Monetary policy, however remained excessively expansionary. While velocity continued to rise, money supply was stable, allowing NGDP to continue increasing (blue area).

It is likely that the surge in Core PCE from that point was the result of a “demand & supply combo”. Interestingly, Core PCE inflation peaked in February 2022, just as the Russian invasion began!

From that point, the rise in NGDP is more “gentle”, reflecting the less “intense” increase in velocity and mostly stable money supply.

RGDP, on the other hand, is almost smack on the post pre Covid19 trend path, and that may be too “hot” given the supply constraints still present. Therefore the above trend NGDP is reflected mostly on higher inflation.

The chart below, in growth form may help. Since the higher (likely not rising) inflation stems from “too much” money (the case when changes in velocity are not adequately off set by money supply changes), if velocity keeps rising, money supply growth will have to fall by more.

This contradicts the view put forth by Steve Hanke referred to above, that “a policy that takes M2 growth to zero spells disaster.”

Just as the policy that increased the money supply when the pandemic hit and velocity tanked was the right policy (imagine the size of the depression that would have occurred if money supply had remained pat), the right policy now, given that velocity is slowly climbing back to its stable pre Covid19 level, is to make money supply growth negative, at least until NGDP growth falls from the present ~9% YoY rate to the 4%-5% rate that prevailed pre pandemic!

The point here is that a judicious monetary policy, that is one that acts sensibly to bring the “inside temperature” (NGDP) back to 4%-5% growth YoY will impart very little pain on the economic patient, something that the blunt “bloodletting” interest rate hikes will not achieve!