The Fed cannot bury something that never existed

Anatole Kaletsky, of Gavekal Dragonomics has written an ignorant, even libelous, piece at Project Syndicate called “Why the Fed Buried Monetarism”. (Friedman must be having a fit in his grave):

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 behavior(!)

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.

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 pre-monetarist 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.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.

Now, look at the main points from Friedman´s 1967 AEA Presidential Address – The Role of Monetary Policy:

What MP Cannot do:

The monetary authority controls nominal quantities-directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity-an exchange rate, the price level, the nominal level of national income, the quantity of money by one or another definition-or to peg the rate of change in a nominal quantity-the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money.

It cannot use its control over nominal quantities to peg a real quantity-the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money.

And (interest rates a bad indicator of the stance of MP)

As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.

What MP can do

Monetary policy cannot peg these real magnitudes at predetermined levels. But monetary policy can and does have important effects on these real magnitudes. The one is in no way inconsistent with the other.

The first and most important lesson that history teaches about what monetary policy can do-and it is a lesson of the most profound importance-is that monetary policy can prevent money itself from being a major source of economic disturbance.

A second thing monetary policy can do is provide a stable background for the economy [i.e.provide nominal stability]

How MP should be conducted

The first requirement is that the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority.

6 thoughts on “The Fed cannot bury something that never existed

  1. Where we have been going with some of these recent posts, including your latest. is that the central banks can’t really control inflation that well. “Inflation” is the residual between nominal demand and productivity. And the Fed can’t control productivity. So why should central banks target inflation?

  2. “I [the journo] asked Mr Carney whether global warming came under the remit of the Governor of the Bank of England.
    He said it did – the stability of the insurance sector which is facing increasing costs and banks facing possible asset write-downs meant this was a matter of global financial stability. Bank of England governor – global economy at risk from climate change”

    http://www.bbc.co.uk/news/business-34396969

  3. “monetary policy can prevent money itself from being a major source of economic disturbance.” – is what Friedman said in 1967 in his address, and that’s exactly what Kaletsky is addressing. Friedman is saying that ‘bad’ monetary policy can have bad effects on the economy, including things like lost output and high unemployment, just like in the Great Depression. Semantics by the present author, trying to make a fellow economist look bad; taking a page out of Friedman’s ad hominem attacks. BTW, I personally think money is neutral so none of this matters, but just pointing out what Kaletsky seems to be saying.

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