In the fog
Two implicit monetary theories
To end users, money is familiar and even ubiquitous; but the plumbing that makes it go is obscure and even esoteric. Add to this the centrality of money to economic life, and the fact that control over that center yields some control over the entire economic system, and we need not be surprised at the difficulties presented by monetary theory. Even at the best of times, central bankers must navigate this fog, but these days both the stakes and the confusion are particularly high.
One side-effect of this is the prevalence and persistence of implicit monetary theories, comforting stories about the relationship between monetary policy and prices. In this post: two such theories that are relevant to current discussions, and why we will probably never be free of them.
Smart journalistic coverage of monetary policy uses what we might reasonably call folk Keynesianism. “Inflation is high because aggregate demand is high relative to aggregate supply. The central bank should raise interest rates, which will have effect X, bringing down aggregate demand and so also inflation.” This is basically IS–LM, but one is free to fill in X with whatever facts are to hand.
Such flexibility is a discursive strength of folk Keynesianism, because there is usually an X that makes the story true enough. It could be that rising rates make mortgages more costly, causing residential construction to slow, lowering incomes in that industry and then more broadly through a multiplier effect. It could be that rising interest rates bring down the prices of financial assets, leaving the public feeling less wealthy and so less inclined to spend. It could be that rising rates increase the return to holding cash, leading the public to hoard, with the same effect.
Such arguments don’t need to be completely precise. They are used to interpret ongoing events, or as a rough guide to policy. They are simple enough to hold together without detailed explanation or careful disentangling of causation.
Folk Keynesianism circulates alongside a more or less implicit monetarism. Writing in the Financial Times last week, Sheila Bair makes it explicit: she lauds Paul Volcker, Fed chair from 1979 to 1987, for keeping money tight come what may, and urges Powell to emulate him.
The argument is based on two main complaints against the FOMC’s current stance. The first is that the Fed has been wrong to place emphasis on increasing overnight interest rates. This approach has meant that the Fed is paying banks not to lend, which Bair argues is unseemly. The second complaint is that the Fed has already implied, in official communications and through the parameters of recent bank stress tests, that they are ready to lower rates again in the event of a recession. Volcker, by contrast, was wise and brave, keeping money tight despite the pain.
Bair was chair of the FDIC during the 2008 crisis, and the US deposit insurance scheme came out of it in better shape than most institutions. I would not dismiss her opinion out of hand. But the explicit monetarist position seems a bit much: “Too much money chasing too few goods and services lies at the heart of this and every other inflationary moment.” Can we really look at this graph and draw the conclusion that excessive money creation is what is driving prices higher?
Concretely, Bair suggests that the Fed stop talking about rates and start talking about monetary aggregates. This would be a huge shift, one that could only be entertained after things had gotten much worse than they are now, and probably a change in leadership at the Fed. Perhaps we should suspend interest on reserves and pivot to big asset sales? But the Fed started paying interest on reserves in 2008, which gives an idea of the kind of circumstances that allow that sort of shift.
There is not, I think, any actual proposal in Bair’s piece. Its purpose is to give voice to the usually implicit monetarist strand of thought.
Forecast: more fog
These theories are widely believed without being precise enough to test. They tend to leave enough wiggle room to evade ever being quite confirmed or junked. Neither theory is particularly right or wrong in this kind of discourse—their function is political.
More generally, there is not a single “right” answer for the Fed at the moment. Even if there is a causal link from monetary policy to US consumer prices, it likely can never be known in advance. Money changes alongside the evolving architecture of global finance and its political-economic and social circumstances. By the time we can see it clearly, it has already changed.
Still, central banks cannot do nothing. Their mandates, and so their credibility and legitimacy, rest on price stability: in exchange for their operational privileges, central banks are expected to keep price growth in check. The assumption that they can in fact do so stays in the background.
So central banks will tighten monetary conditions, and inflation will subside, sooner or later. The causal chain is likely to remain murky. We certainly won’t get to repeat the experiment, and multiple interpretations will remain possible.
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