By Dr Frank Shostak
In an interview with National Public Radio’s “Morning Edition” program on Thursday March 25 2021, Fed Chair Jerome Powell said that even with the economy rebounding faster than expected, any change in monetary policy would happen “very, very gradually over time and with great transparency. Rate increases would only be considered when the economy is all but fully recovered”. Powell also said that “as we make substantial further progress towards our goals we will gradually roll back, the $120 billion monthly bond purchases”.
Currently the Federal Reserve employs a transparent monetary policy framework in order to generate an environment of economic stability. By this framework, the key for economic stability is that the central bank should state clearly the likely course of the monetary policy ahead. Note that on this way of thinking, expected monetary policy is a factor of stability whilst unexpected policy sets shocks and instability.
For instance, if the central bank raises interest rates by 0.5 percent, and if market participants anticipated this action, asset prices will reflect this expected increase prior to the central bank raising interest rates. Note that once the central bank lifts the interest rate by 0.5 percent this increase will have no effect on asset prices since it is already imbedded in asset prices.
Should, however, the central bank raise interest rates by 1 percent, rather than the 0.5 percent expected by market participants, then the prices of financial assets will react to this additional increase.
The transparency framework that Fed policy makers employ is based on the ideas of the Chicago School economists Friedman and Lucas.
In his writings, Friedman argued that there is a variable lag between changes in money supply and its effect on real output and prices. According to Friedman, in the short run changes in money supply will be followed by changes in real output. However, in the long-run changes in money will only have an effect on prices. This means that changes in money with respect to real economic activity tend to be neutral in the long-run and non-neutral in the short-run.
Friedman held that if the central bank were to follow a constant money growth rule, this would cause money to become neutral with respect to real economic activity also in the short-run. The only effect that money would have is on general prices.
On this way of thinking, various disruptions in real economic activity are caused by unpredictable monetary policies. These policies generate volatility in the money supply growth rate. This in turn causes fluctuations in real economic growth. Hence, according to Friedman by making the money supply growth rate stable the Fed could eliminate disruptive economic fluctuations.
Similarly, to this line of thinking by Friedman, in his Nobel lecture Lucas suggested that if monetary growth is expected, then people will adjust to it rather quickly and there will not be any real effect on the economy. According to Lucas, expected money supply growth is going to result in the corresponding increase in the prices of goods, which is going to offset the increase in the monetary spending.
However, if the growth rate of money was not anticipated then according to Lucas, it is going to stimulate production. Following this way of thinking only unanticipated monetary expansion can increase economic growth. This economic growth however is likely to be of an unstable nature.
Both Friedman and Lucas are of the view, that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth.
Money, expectations and economic growth
Following Richard Cantillon, we suggest that even if everyone were to anticipate precisely the money supply growth rate there are always going to be first recipients of the new money and late recipients. The early recipients could buy goods at unchanged prices whilst the later recipients of money would likely have to pay much higher prices.
This is going to set in motion the transfer of real wealth from the last recipients to the early recipients of money and this in turn is likely to change the relative prices of goods and services. As a result, money is not going to be neutral.
Even if the money is pumped in such a way that everybody received it instantaneously, changes in the demand for money will vary – after all every individual is different from other individuals -there will always be somebody who will spend the newly received money before somebody else. This is likely to result in the redirection of real wealth to the first spender from the last spender. Given that money was generated out of “thin air” this will likely result in the depletion of the pool of real savings through the exchange of nothing for something, which in turn is likely to undermine real economic growth.
One could however, make a case that through the overuse of the existing infrastructure the unexpected monetary increase could strengthen economic growth in the short-run.
However, in the medium to longer-term the weakening in the pool of real savings (due to the exchange of nothing for something) is going to undermine the real economy. Hence, we suggest that over time unanticipated money growth is going to undermine real economic growth via the dilution of the pool of real savings.
Note again, that to stabilize individuals’ expectations the Fed will be compelled to tamper with the growth rate of money supply this however, is going to set in motions disruptions in terms of boom-bust cycles.
We can conclude that both expected and non-expected money supply growth will weaken the pool of real savings, which over time will lead to a weakening in real economic growth and likely to set in motion economic instability.
We also suggest that Friedman’s constant money growth rule cannot make money neutral since the constant money growth rule is still about increases in money supply despite it being at a constant rate. This means that in the Friedman’s framework we will also have an exchange of nothing for something and therefore boom-bust cycles and economic instability.
The Fed’s transparent monetary policy cannot prevent economic bust
In February 2021 the yearly growth rate of our measure of money stood at almost 80% (see chart). The unprecedented increase in the US money supply growth rate has generated gigantic monetary bubble.
We suggest that any softening in the annual growth rate of money supply is likely to burst the gigantic bubble. It could be either because of the Fed’s mild tightening in response to the increase in inflationary expectations or because of a decline in the yearly growth rate of bank’s inflationary lending. Hence, we hold that regardless of how transparent the Fed is going to be the bubble is going to burst in a big way.
In the words of Ludwig von Mises,
The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.
The suggestion that it is possible to avoid the outcome of loose monetary policies by means of transparent policies is erroneous. It is not possible to avoid the effects of a given cause, which in turn means that it is not possible to undo the damage that monetary pumping has inflicted. Regardless of policy transparency once a tighter monetary stance is introduced, it is going to set in motion an economic bust.
In conclusion, we can suggest that it is not possible to deflate the present gigantic monetary bubble without a severe economic bust. A policy of transparency employed by the Fed cannot prevent the inevitable bust. We suggest that neither Friedman’s constant money growth rule nor Lucas’s perfect anticipation of money growth can eliminate boom-bust cycles and thus set the platform for economic stability. In order to make money truly neutral with respect to the real economy it is necessary to close all the loopholes for the generation of money out of “thin air”. The major loopholes are the central bank buying of assets and the fractional reserve lending by banks. Furthermore, what is required for economic growth is a growing pool of real savings, which supports various individuals that are engaged in the enhancement and the maintenance of the infrastructure. The ever-expanding government and central bank intervention with markets remains a major obstacle for the increase in the pool of real savings.