The Mercatus Center has just published an excellent new working paper by Robert Hetzel. Here’s the abstract:
In response to the pandemic, which unfurled starting in March 2020 and raised unemployment dramatically, the FOMC adopted a highly expansionary monetary policy. The policy restored the activist policy of aggregate demand management that had characterized the 1970s. It did so in two respects. First, the FOMC rejected the prior Volcker-Greenspan policy of raising the funds rate preemptively to preserve price stability. Second, through quantitative easing, it created an enormous amount of money by monetizing government debt. In the 1970s, activist policy was destabilizing. Reflecting the “long and variable lags” phenomenon highlighted by Milton Friedman, a temporary reduction in unemployment from monetary stimulus gave way in time to a sustained increase in inflation. In response, the succeeding Volcker-Greenspan FOMCs rejected an activist monetary policy in favor of a neutral policy. That policy concentrated on achieving low trend inflation and abandoned any attempt to lower unemployment by exploiting the inflation-unemployment trade-offs promised by the Phillips curve. The success or failure of the FOMC’s activist monetary policy offers yet another opportunity to learn about what kinds of monetary policies stabilize or destabilize the economy.
Hetzel has closely followed Fed policy for many decades, and has a deeper understanding of how the Fed works than almost anyone else I know. In 2020 and 2021, Hetzel saw many warning signs in the statements made by Fed officials, which emphasized the need to run the economy hot in order to create jobs. I initially dismissed these statements as empty rhetoric to please politicians and pundits, and instead focused on the Fed’s commitment to its new “flexible average inflation targeting” policy, which would assure an average inflation rate of 2%. It turns out that I was wrong and Hetzel was right—the 1960s-era views expressed by Powell and other Fed officials were the real policy, and FAIT was just empty rhetoric.
You might argue that lots of people saw the inflation coming, so why focus on Hetzel? What makes Bob Hetzel so unusual is that he also correctly diagnosed the Fed’s policy errors back in 2008, a time when Fed policy was too contractionary. Many of the people who worried about inflation in 2021 were permahawks, who were right in 2021 but totally wrong in 2008. There are only a tiny number of people who correctly called Fed mistakes in both cases (Tim Congdon and Lars Christensen also fall into this group.) Permahawks will be right when policy was (ex post) too easy, and permadoves will be right when policy was too tight. Yawn.
In a rational world, this record of success would lead people to take Hetzel’s views much more seriously. I hope his paper is read by professional economists who wish to learn why they got things wrong in 2008, or in 2021. I worry that people tend to dismiss relatively non-technical studies where the analysis is informed by a deep knowledge of monetary history.
Please read the whole thing.
READER COMMENTS
Jon Murphy
Apr 28 2022 at 11:45am
Thanks for sharing. I was one of those permahawks in 2008 who didn’t understand why inflation never happened and came up with a lost of post hoc explanations (To be fair, I was an undergrad, but still). I’m looking forward to seeing what Hetzel has to say.
Thomas Lee Hutcheson
Apr 30 2022 at 7:48am
Hey what a refreshing message.
While we are going to confession I will say I was late to see that Fed instruments were too expansionary** until September when TIPS expectations moved significantly away from target. And even then (and even now though with ever decreasing conviction) I thought the average inflation policy was correct and that the Fed had just mis-estimated the effects of its instruments.
** Complaining about Federal spending as inflationary, however early, does not count. A proper neo Liberal complains only about spending with NPV< zero. 🙂
Spencer Bradley Hall
Apr 28 2022 at 12:22pm
Hetzel: “The monetary aggregates ceased to offer a reliable measure of the liquidity of the public’s asset portfolio.”
Tripe. Both the 10-month rate-of-change and the 24-month rate-of-change were perfectly explanatory (using either required reserves or bank debits). Obviously, no money supply figure standing alone is adequate as a “guidepost” to monetary policy.
Spencer Bradley Hall
Apr 28 2022 at 3:08pm
Economists aren’t conceptual thinkers. The monetization of time deposits led up to the Volcker era, and the transition from clerical processing to electronic processing. This accelerated the transaction’s velocity of funds and offset the impoundment of monetary savings in the banks. During this period the markets usurped the FED’s open market power as the fed funds activity was always on top of the brackets.
1981 was the turning point / saturation point. Afterwards an increase in time deposits reduced money velocity as banks don’t lend deposits. Deposits are the result of lending. The growth of bank-held savings was the cause of the Great Moderation, the reduction in velocity (as predicted in 1961). As the absolute volume and percentage of time deposits grew secular stagnation cropped up (as predicted in 1961).
First, the distributed lag effects of money are not “long and variable’. They are mathematical constants. Contrary to Hetzel, the 1st qtr. of 2020 was already going to be negative.
Larry Siegel
Apr 30 2022 at 2:30am
All *good* economists are conceptual thinkers. There are plenty of hack economists, but they don’t add much to the field unless they happen to gather data that are useful to good economists.
Brandon
Apr 29 2022 at 12:49am
Interesting as usual, Scott, but I thought this was going to be about Fred Foldvary…
marcus nunes
Apr 29 2022 at 4:46pm
It is important to note that from the start of the pandemic to July 2021, the Fed was “perfect”. Through its monetary actions, it presided over the shortest recession on record and an extremely fast recovery!
If only the Fed had NGDP-LT as a target, the added demand side inflation that “took over” after July 21 would not have happened.
I try to “document” those arguments here:
https://marcusnunes.substack.com/p/the-feds-monetary-policy-from-the?s=w
Peter Bias
Apr 30 2022 at 2:48pm
Scott, as usual the monetarists prevail. And sorry Spencer, I disagree. I believe that money still rules as a guide to monetary policy.
Just look at the left hand side of the dynamic equation of exchange, i.e. the summation of the rates of growth of M2 and M2V. Go on FRED and check it out. The sum of those has been running hot (averaging about 13% rate of growth) for over a year now, and almost all of it is money rate of growth, not velocity. Given that the dynamic equation of exchange is a macroeconomic, ever-equal, contemporaneous constraint, high inflation is as predictable as the sun rising tomorrow – the RHS has to equal the LHS – we gotta get 13 % over there too.
The Fed is fully creating this inflation. Period.
Comments are closed.