It is no secret that the hubris from the economists at the Federal Reserve is palpable, but a recent piece from San Francisco Fed president John Williams takes the cake. In the bank’s monthly economic letter Williams does a premature victory dance for the unconventional monetary policy and bashes the great Milton Friedman in the process.
Below are some excerpts from his paper with my comments.
Milton Friedman (1970) famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output” (p. 24). We are currently engaged in a test of this proposition. Over the past four years, the Federal Reserve has more than tripled the monetary base, a key determinant of money supply. Some commentators have sounded an alarm that this massive expansion of the monetary base will inexorably lead to high inflation, à la Friedman.
So far so good, but then Williams goes off the rails. In the next paragraph he tells us that “Inflation in the United States is the dog that didn’t bark.” It is not that Mr. Williams isn’t correct. Inflation has indeed been low of the past four years. The problem, as Milton Freidman taught us, is that monetary policy works with long and variable lags. It could be that inflation is the dog that didn’t bark—yet. To Wit:
As Figure 1 shows, [inflation] has averaged less than 2% over the past four years. What’s more, as the figure also shows, surveys of inflation expectations indicate that low inflation is anticipated for at least the next ten years.
Williams then tells us that this time is different—the four most dangerous words in finance. The this-time-is-different mentality is how bubbles form and policy errors are committed.
In my remarks, I will try to reconcile monetary theory with the recent performance of inflation. In my view, recent developments make a compelling case that traditional textbook views of the connections between monetary policy, money, and inflation are outdated and need to be revised.
Williams then informs us why consumer inflation has remained low despite an unprecedented expansion in the monetary base (weak economy, deleveraging, etc.) which is all true. He then addresses the view that excess reserves may pose a risk of future inflation once the economy recovers. But Williams quickly discredits this view. He maintains that higher future inflation can’t happen because the Fed now pays interest on reserves.
But, once the economy improves sufficiently, won’t banks start lending more actively, causing the historical money multiplier to reassert itself? And can’t the resulting huge increase in the money supply overheat the economy, leading to higher inflation? The answer to these questions is no, and the reason is a profound, but largely unappreciated change in the inner workings of monetary policy.
The change is that the Fed now pays interest on reserves. The opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate (see Board of Governors 2011). Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy. Instead, what matters for the economy is the level of interest rates, which are affected by monetary policy.
What Mr. Williams is overlooking is that in an economic expansion, banks aren’t interested in holding T-bills or T-bill substitutes. They want to redeploy their low risk liquid assets into higher yielding loans. In an economic recovery, if the Fed is too slow to raise rates banks may lend their excess reserves thereby expanding the money supply.
Notwithstanding Mr. Williams’ piece, the verdict on unconventional monetary policy is still out. The last we looked, the Fed still had over $2 trillion on its balance sheet. Mr. Williams is counting his chickens before they hatch. As the video below shows, premature celebrations have a tendency of ending in, well, disaster.
Jeremy Jones, CFA
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