In a recent post I argued that Milton Friedman would have been extremely critical of the Fed’s tight money policy since late 2008. I cited a number of factors, including:
1. He said in late 1997 that the ultra-low interest rates in Japan were actually a sign that money had been too tight.
2. Late in his career he moved from money targeting toward other options like inflation targeting. He even endorsed Hetzel’s proposal to target TIPS spreads.
3. I forget to mention the interest on reserves policy, which is very similar to the 1936-37 policy of doubling reserve requirements. Both programs only raised short term rates by about a 1/4 point, but Friedman (and Schwartz) understood that the 1937 policy was highly contractionary despite the tiny interest rate increase, because it sharply reduced the money multiplier. He would have been a severe critic of the current IOR policy.
But there was one weakness in my argument, which I acknowledged. Friedman was famous for favoring steady money supply growth, and M2 and MZM grew quite rapidly during 2008-09. So would Friedman now have opposed stimulus, despite the fact that growth in these aggregates fell close to zero after mid-2009? John Taylor thinks so.
But I have found an even more recent Friedman article that sharply undercuts the only plausible argument that Friedman would have been with the inflation hawks. In 2003 he wrote a very interesting article on recent trends on monetary policy, and basically made peace with the new Keynesian inflation targeting approach:
To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output.
Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability, as Chart 1 illustrates. Yet since the mid ’80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity. This sounds easy but it is not — because of the long time lag between changes in money and in prices. It takes something like two years for a change in monetary growth to affect significantly the behavior of prices.
The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Chart 2 shows what happened. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.
The relatively low and stable inflation for this period documented in Chart 1 means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.
Some economists have expressed concern that recent high rates of monetary growth have created a monetary overhang that threatens future inflation. The chart indicates that is not the case. Velocity is precisely back to trend. There is as yet no overhang to be concerned about. (Italics added.)
Note that Milton Friedman is criticizing “some economists” who have “expressed concerns that the high rate of money growth . . . threatens future inflation.” Today those “some economists” are obviously monetarists, Austrians, and conservative Keynesians (but not all in those camps.) And Friedman is telling his fellow conservatives (from the grave) that they are wrong, that this “is not the case.”
Friedman would have understood that the financial crisis was a special case that led to a rush for liquidity and safety, and a temporary fall in M2 velocity. He would have seen the low interest rates and low TIPS spreads as indicators of tight money. He would have favored temporarily allowing higher M2 growth to offset the low velocity, until the economy was back to normal. Somehow modern conservatives seem to merely recall the bumper sticker message “stable money growth” but overlook the nuanced and highly sophisticated monetary analysis that made Milton Friedman an intellectual giant.
HT: Jeffrey Hummel
Tags: Milton Friedman