The peculiar persistence of monetary policy denialism
When I was in grad school in the late 1970s, there was increased interest in the “monetary ineffectiveness proposition”, which posited that money was neutral and monetary policy did not impact real variables. There was virtually no interest (at Chicago) in the claim that monetary policy could not impact nominal variables, like inflation and NGDP. By the early 1990s, there was no interest in the nominal ineffectiveness view in any university that I’m aware of.
And yet today I see lots of people denying that monetary policy can control nominal variables. They often make arguments that are completely irrelevant, such as that the monetary base is only a tiny percentage of financial assets. That would be like saying the supply of kiwi fruit can’t have much impact on the price of kiwi fruit, because kiwi fruit are only a tiny percentage of all fruits.
Beyond the powerful theoretical arguments against monetary policy denialism, there’s also a very inconvenient fact for denialists; both market and private forecasters seem to believe that monetary policy is effective. Let’s take a look at the consensus forecast of PCE inflation over the next 10 years (from 42 forecasters surveyed by the Philadelphia Fed):
Notice that most of those numbers are pretty close to 2%. The Fed’s official long run target is headline PCE inflation, however in the short run they are believed to target core PCE inflation, which factors out wild swings in oil prices. Core PCE inflation is expected to come in at 1.8% this year. That may reflect the strong dollar, which holds down inflation. They forecast 2.0% inflation for the 2016-2025 period.
Now think about how miraculous that 2.0% figure would be if monetary policy were not determining inflation. Suppose you believed that fiscal policy determined inflation. That would mean that professional forecasters expected Trump and Congress to come together with a package to produce exactly 2% inflation. But I’ve never even seen a model explaining how this result could be achieved. People who like the fiscal theory of the price level, such as John Cochrane, usually talk about the history of inflation in the broadest of terms. Thus inconvenient facts such as the fall in inflation just as Reagan was dramatically boosting deficits are waved away with talk of things like the 1983 Social Security reforms, which reduced future expected deficits. But unless I’m mistaken, there’s no precision in those models, no attempt to explain how fiscal policy produced exactly the actual path of inflation. (This is from memory, please correct me if I’m wrong.)
Another counterargument might be that 2% inflation is “normal”, and thus might have been caused by some sort of structural factors in the economy, not monetary policy. But of course it’s not at all normal. Prior to 1990, the Fed almost never achieved 2% inflation; it was usually much lower (gold standard) or much higher (Great Inflation and even the Volcker years.) Since 1990, we’ve been pretty close to 2% inflation, and this precisely corresponds to the period when the Fed has been trying to achieve 2% inflation. Even the catastrophic banking crash of 2008-09 caused inflation to only fall about 2% below target, as compared to double digit deflation during the 1931 crisis.
So private sector forecasts seem to trust the Fed to keep inflation at 2%, on average. But how can the Fed do that unless monetary policy is effective?
How about market forecasts? Unfortunately we don’t have a completely unbiased market forecast, but we do have the TIPS spreads:
Notice the 5-year and 10-year spreads are both 2.01%. That’s actually closer to 2% than usual, but a couple caveats are in order. First, the CPI is used to index TIPS, and the CPI tends to show higher inflation that the PCE, which is the variable actually targeted by the Fed. So the markets may be forecasting slightly less than 2% inflation. Notice the Philly Fed forecast calls for 2.0% PCE inflation and 2.22% CPI inflation over the next decade. So perhaps the TIPS markets expect about 1.8% PCE inflation.
On the other hand, TIPS spreads are widely believed to slightly understate expected CPI inflation. That’s because conventional bonds are somewhat more liquid than TIPS, which means they are presumably able to offer a slightly lower expected return. If so, then expected CPI inflation is slightly higher than the TIPS spreads. To summarize, the TIPS markets are probably predicting slightly above 2.01% CPI inflation, and the expected PCE inflation rate is about 0.22% below that. In other words, TIPS markets predict that PCE inflation will run about 0.22% below a figure that is slightly above 2.01%. That sounds like a figure not very far from 2.0%!
Thus both private forecasters and market participants seem to be expecting roughly 2% PCE inflation going forward. There are lots of other figures they could have predicted, including the 4% inflation of 1982-90, or the zero percent average of the gold standard, or the 8% figure of the 1972-81 period, etc., etc. Why 2.0%? Is it some miraculous coincidence? Or is it because the Fed determines the inflation rate, and people expect the Fed will deliver roughly on target inflation, on average, for the foreseeable future?
Just to be clear, I’m not saying the forecasts will always be this close. I would not be shocked if the next Philly (quarterly) forecast bumped up to 2.1%, perhaps reflecting the impact of Trump’s election. My point is that it’s difficult to explain any figure that is close to 2% with a “fiscal theory of the price level”. Or “demographics”. You need to focus on monetary policy, which drives the inflation rate. And that means, ipso facto, that monetary policy also determines NGDP growth. If trend RGDP were to slow, the central bank could simply raise the inflation target to maintain stable NGDP growth. Thus NGDP growth is not driven by structural factors such as productivity, regulation, demographics, fiscal policy, etc., it’s determined by the Fed.
There is no question in my mind that the Fed could generate a 4% average rate of NGDP growth, or any other figure. The only question is whether or not they wish to.
PS. Of course there’s lots of other evidence against denialism. For instance, exchange rates often respond strongly to unanticipated monetary policy decisions, and almost always in the direction predicted by monetarists, and denied by denialists.
PPS. I’m not a Holocaust denialist, a global warming denialist, or a monetary policy denialist. But I am a fiscal policy denialist and a conspiracy theory denialist, so I’m not opposed to denialism, per se.
PPPS. Regarding the kiwi example, an even better analogy would be the claim that a stock split of Disney can’t affect the nominal price of individual Disney shares, because Disney is only a small share of the entire stock market. Of course that’s wrong, and so is monetary policy denialism.