Karl Smith on Monetary Policy Puzzles
Karl Smith has a new piece in Bloomberg discussing the impact of monetary policy on economy. He argues that the standard model doesn’t explain what’s been happening to the economy. I partly agree, but only because what is now the “standard model” is not a state of the art model of monetary policy.
I’ve done numerous posts pointing out that prior to 2008, prominent economists like Ben Bernanke, Frederic Mishkin and Milton Friedman completely rejected the claim that interest rates represent the stance of monetary policy. But we’ve entered a new Dark Ages for macroeconomics, reverting to the once discredited Keynesian views of the 1950s. Here’s Smith:
The way monetary policy is understood to work is that the central bank boosts rates to suppress demand throughout the economy and lowers them to achieve the opposite effect. And the latest data would suggest the Fed tightened policy precisely enough to temper demand and squeeze out excess inflation without sparking a massive rise in unemployment. Yet it’s difficult to identify any sector of the economy outside of housing in which monetary policy has been instrumental in curbing demand.
Unfortunately, this does accurately describe the current view, but it is not how monetary policy works. Instead, the Fed adjusts its policy tools to impact the supply and demand for base money, which then impacts nominal GDP growth. Monetary policy is not credit policy.
This leads to confusion about inflation:
The Federal Reserve Bank of Cleveland produces a measure that calculates how much supply-side factors contribute to inflation. Subtracting that measure from actual inflation gives a rough estimate of how much excess demand is contributing to rising prices. The most striking thing to note is that the portion of inflation attributed to excess demand has declined a mere 2.3 percentage points since its peak in September of 2022, from 7.3% to 5.0%. The overall consumer price index, though, has decreased by 5.9 percentage points since peaking at 9.1% in June 2022.
Here it’s worth noting that the Fed prefers the PCE inflation index, which peaked at 7.1% and has fallen to 3%. But I do not dispute the claim that only about 2.3 percentage points of the inflation decline (however measured) is related to a slowdown in the growth of aggregate demand. At the peak, headline inflation was briefly pushed above the underlying inflation rate by supply problems, and recent data shows an inflation rate currently below the underlying rate due to improvement in the supply side of the economy. A reasonable guess might be that the underlying inflation rate fell from roughly 5.8% to 3.5%—that’s the part of inflation caused by monetary policy.
In previous posts, I’ve shown that virtually all of the cumulative excess inflation since 2019 can be explained by excess growth in aggregate demand (NGDP). Supply shocks push inflation higher during some periods, and lower during others, but do not affect the long run inflation rate. There is no mystery to explain—monetary policy explains the long run trend in inflation.
Why did economists assume that a recession would be required to bring inflation back to normal? Probably because the US has never had a soft landing. But there’s no obvious theoretical reason why a soft landing is impossible. In theory, if you gradually slow NGDP growth to a sustainable rate of about 4%, you can get back to 2% inflation without a recession. I don’t know if we’ll be able to do that (NGDP growth is still running at about 6%), but it might happen.
Because American economists had never seen a soft landing, they built a flawed theory that monetary policy worked by impacting real output, which then slowed inflation. To bring inflation down to 2% (it was assumed), you needed to create a recession. This is often called the Phillips Curve theory. But it’s not actually how monetary policy works. Here Smith seems to use data for real output as an indicator of aggregate demand:
If tighter monetary policy has had a small effect on consumers, then it must have had an outsize effect on businesses. Indeed, growth in business investment slowed from 5.8% year-over-year in the third quarter of 2022 to 4% in this year’s third quarter. But the slowdown is small both in absolute terms and relative to past tightening cycles. . . .
So, if tighter monetary policy has mostly failed to curb demand in the broader economy, then what did?
There are two problems here. Aggregate demand is GDP, not investment. In addition, it’s nominal GDP, not real output. I believe Smith is citing growth rates for real investment, which slowed only modestly. But 12-month nominal business investment growth slowed sharply between 2022:Q3 and 2022:Q3, from 13.1% to 6.8%.
Monetary policy does not work by slowing real consumption or real investment. It does not even work by slowing real GDP. It works by slowing nominal spending growth (NGDP growth.) How that slowdown affects real output depends on the speed at which NGDP growth slows, and the pace at which wage moderation occurs.
If the Fed’s 2% inflation target has some credibility, then wage moderation is easier to achieve. And if wage moderation occurs at a time when NGDP growth is slowing gradually, then a soft landing is possible.
If you go back and read the past 55 years of the business media, you’ll see one article after another discussing “puzzles”, which are anomalies that cannot be explained by the flawed Keynesian model that many economists and journalists utilize. Smith is correct that there is something wrong with the conventional model of monetary policy. But that’s because today’s conventional model relies on once discredited Keynesians ideas, such as the claim that higher interest rates represent tighter money. (Check out interest rates in Argentina!) We need to rediscover the insights of people like Ben Bernanke (from 2003, before macroeconomics entered a new Dark Age):
The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. . . .
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.
PS. One reason why people wrongly assume that monetary policy works by changing investment is that investment is especially cyclical. But that’s because the public smooths consumption for reasons explained by Milton Friedman way back in the 1960s. If consumption is smoother than national income, then investment will necessarily be more volatile than GDP.
PPS. I mention the past 55 years of media because the first example I can recall is from the late 1960s, when economists were “puzzled” by the fact that higher interest rates and tax increases were failing to slow inflation. This led the government to opt for price controls. We are still being puzzled by the failure of interest rates to do what we expect, as we’ve never learned the lessons taught by Milton Friedman. Here he has a similar lament in 1998:
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. . . . After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
I guess not.