Should monetarism stage a comeback?
Kevin Warsh wants to revive Milton Friedman’s ideas, but monetary signals are often vague and noisy
Chris Giles
US Federal Reserve chair Kevin Warsh is a huge fan of the late economist Milton Friedman, the founding father of monetarism.
And although targeting the money supply went out of fashion in the 1980s after its failure to control inflation adequately, Warsh is seeking to use his task forces to breathe new life into the idea.
“I was blessed to be a student of [Friedman],” the Fed chair told the Hoover Institution last year, adding that “monetary policy and inflation [are] about money”.
Leading the Fed has not dimmed that zeal.
At his Jackson Hole speech in August, Warsh said: “We should pay attention to money created by the central bank and money that comes from the banking and financial systems.
It’s true that financial innovations and other factors alter the mechanics that link the monetary base, the velocity of money and the broader economy.
But that is scarcely a reason to ignore the ultimate effects of money on financial conditions and prices.”
Warsh has put two of his five task forces to work to bring monetarism back to the centre of Fed thinking.
The balance sheet policy task force will examine the money created by the central bank itself, which is something Warsh has long wanted to limit in what he has called “practical monetarism”.
The inflation frameworks task force will consider the effect of money created by the banking and financial systems on inflation.
Why revisit monetarism?
I am not going to delve into the long economic debate over the role of money in an economy, but will simply note that Friedman’s ideas became fashionable in the 1960s and 1970s following the failure of postwar Keynesian economics to control inflation.
They were further boosted internationally by the Bundesbank’s remarkable success in achieving price stability in the 1970s using money supply as its primary indicator.
But monetarism fell by the wayside a decade later when monetary indicators increasingly lost their ability to predict and target inflation.
The waxing and waning of monetarism’s popularity was primarily a practical matter, although that did not stop huge doctrinal disputes in the profession and in politics.
Monetarism was seen as rightwing because of its association with former US president Ronald Reagan and former UK prime minister Margaret Thatcher.
Meanwhile, those who get great pleasure in shouting “neoliberalism” and suchlike tend to overlook the Bundesbank or otherwise classify it as a bastion of conservatism.
Back to the present.
The main reason we are talking about monetarism again is practical.
The money supply grew sharply during the post-Covid-19 pandemic period, especially in the US.
Inflation followed soon after across the globe, as the chart below shows.
The logic that turns this chart into conjecture is as follows: the private sector held large money balances because the government sent it cheques while the Fed expanded quantitative easing and pandemic restrictions limited face-to-face transactions.
According to the monetarist outlook, the rise in money balances was a sure sign that a surge of spending and inflation was coming. Prominent monetarists Tim Congdon and Steve Hanke noticed this and correctly predicted inflation trouble.
The case for resurrecting monetarism
It is obvious that excess money supply can generate inflation and the pandemic experience certainly tells us that ignoring money in an economy can be a serious oversight.
At a minimum, Warsh is correct to call attention to the money supply.
That is, after taking account of known reasons for monetary moves that are unlikely to affect prices, such as financial innovations and other developments that might affect the velocity of money.
The point of that caveat is to remember that if the speed that money flows around the economy slows — for example, if people cannot spend it in a pandemic — a larger stock will not necessarily be inflationary.
Interesting 2023 research from the Bank for International Settlements found that money supply movements generally do not matter if inflation is close to target.
But during a highly inflationary episode, money’s importance grows strongly as a predictor of inflation.
In short, it would be very odd for monetary policymakers not to consider the potential effect of money on the price level and to think the interest rate is the sole thing that matters for the transmission of policy to inflation.
Bank of England chief economist Huw Pill in 2022 concluded that central bank policies in practice owe more to monetarists “than we conventionally admit”.
The case for caution
Since I am making the case that this is a practical question and not a battle between schools of thought, it is important to consider reasons to be cautious about a wider adoption of monetary analysis in central bank practice.
The pandemic experience is less convincing than it might seem from the chart above.
If there had been a sudden increase in money balances that spurred spending and inflation, you would expect a roughly uniform increase in the price level.
But the European experience in 2022 was of an inflation overwhelmingly concentrated in energy and food prices.
This suggests a supply shock, as European Central Bank chief economist Philip Lane has argued.
In addition, former BoE deputy governor Ben Broadbent in 2023 noted that the monetarist argument did not fit the post-pandemic data well because consumption was lower than expected.
Monetarism also raises the vexed question of economic causality.
Using US data and playing with AI models, it is easy to demonstrate that statistical causality tests can show both that money supply growth causes inflation and vice versa.
The chart below shows that the money and inflation cycles were often out of sync, particularly in the 1970s, so movements in one appear to cause the other.
In other words, you can choose a narrative, as long as you do not confuse statistical causation tests with genuine economic causation.
Subsequent BoE research has shown that money is a fantastic indicator of demand growth over very long periods of between 32 and 64 years, but pretty useless for the short time horizons needed for setting monetary policy.
Central banks should look closely at monetary indicators and adopt broad monetarist insights, but not be naive.
They must recognise that monetary signals are often vague and noisy.
And while policymakers should support more thinking about money, they should be suspicious of any Warsh task force calling for a revolution and a return to crude monetary targets (which, in any case, is highly unlikely).
What are monetary aggregates saying now?
The simple answer is not much.
Money supply growth has been rising this year, but it is not remotely out of line with the pre-pandemic period in the US, Eurozone, UK and Japan.
At the margin, this is a reassuring message about inflation.
The rate of price rises is uncomfortably high, but monetary indicators suggest it won’t persist.
Soumaya Keynes highlights the contradictory evidence on AI and inflation.
I argued it is a toss-up between the US and France on which G7 country will have a fiscal crisis first.
In the UK, it is Budget week.
On the Unhedged podcast, Katie Martin and I agreed that a “do no harm” approach was wise.
We shall see tomorrow.
One last chart
When we are thinking about money supply, we should also consider new forms of money such as stablecoins, which are cryptocurrencies pegged most often to the dollar.
The standard journalistic adjectives to describe these digital assets are “fast growing” and “booming”.
Take a look at the chart below.
This year, US dollar stablecoins in circulation have begun to shrink.
This makes fears of the digital assets destroying some small countries’ domestic currencies and hopes they would provide cheap financing for US debt appear for the birds.
If you read my newsletter from last summer, you will know this makes me happy.
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