When I listen to discussions of monetary policy, I’m often struck by the extent to which outdated terms and concepts are fundamental to the conversation. I don’t mean that the academic discourse is backward—in fact, it moves along rather quickly. But discussions among practitioners, and in the financial press, fall back on the same obsolete ideas over and over.
Obsolete idea #1: The CPI as a central indicator for monetary policy
When the conversation turns to inflation, most of the time it’s assumed that we’re talking about the Consumer Price Index, as if that were the only price index that could conceivably matter. In reality, of course, there are plenty of other price indices—the Producer Price Index, the GDP deflator, nominal wages—with an equal or better claim to relevance in monetary policy. The CPI is not even close to the correct measure for the purposes of either output stabilization or efficient nominal contracting.
Non-economists, of course, often assume that the Consumer Price Index is important because they have a deeply flawed understanding of what the Fed does. They think that inflation is bad because stuff costs more, making them poorer—but this isn’t really “inflation”, it’s the relative change in prices and wages. To the extent that the Fed controls “inflation”, it controls the overall price level, which includes both wages and consumer prices; it can’t repeal the laws of supply and demand and make workers’ labor more valuable in terms of goods and services. In fact, any attempt to do this (by, say, implementing sudden deflation and exploiting the fact that wages are stickier than prices) would be deeply contractionary.
The Consumer Price Index is a perfectly sensible way to make cost-of-living adjustments to Social Security. But there’s no reason save sheer inertia for it to be considered so fundamental to monetary policy.
Obsolete idea #2: the NAIRU
The “Non-Accelerating Inflation Rate of Unemployment” dates back to Milton Friedman and his dispute with the Old Keynesians. At the time, it was an excellent contribution: based merely on a short-term correlation, the Old Keynesians (despite having no good theory to back themselves up) thought that there was a long-term tradeoff between inflation and unemployment. Friedman argued, to the contrary, that there was a “natural rate of unemployment” pinned down by real factors in the labor market, and that at best monetary policy could manipulate this outcome in the short run. Any attempt to keep unemployment below its natural rate would force the Fed into an endlessly accelerating spiral of inflation.
This is indeed a great conceptual insight—but that doesn’t make it a useful way to implement monetary policy in practice. The problem is that it’s very difficult to know what the “NAIRU” really is. As Nancy Stokey pointed out in a 2000 interview:
I think [the NAIRU] is not really such a good one. And I think that the empirical evidence points in that direction pretty strongly. In the 1960s people would have said the NAIRU was around 4 percent, then it crept up to around 8 percent, leveled off and remained there for a while. Now it’s crept down, and I guess it’s around 4 percent again. A number that is as variable as that over a few decades is probably not a good number to build policy around. It doesn’t seem to be a stable number.
It is far simpler and more accurate to target wage inflation instead. After all, the logic of the NAIRU tells us that an attempt to bring unemployment below its natural level inevitably leads to inflation—and, in particular, that inflation in wages is a very good measure of the extent to which labor markets are being overstimulated. If we keep wage inflation at a stable level, we can be sure that we’re staying somewhere in the neighborhood of the NAIRU: there’s no need to make clumsy guesses about what the underlying quantity might be.
Obsolete idea #3: Monetary Aggregates
Anyone learning about monetary economics is sure to run into a bewildering array of “monetary aggregates”: M1 (currency plus checking deposits), M2 (M1 plus savings deposits, small time deposits and money market deposit accounts), MZM (M1 plus savings deposits and all money market funds), and so on. One might be led to believe that these are key quantities for conducting monetary policy. This is not even close to being true.
In theory, monetary aggregates might be useful because they provide ways to represent the “M” in the equation of exchange, MV=PY. The idea is that if velocity (the “V” term) is stable, keeping “M” on a steady trajectory will help to stabilize prices (“P”) and more broadly nominal GDP (“PY”). Unfortunately, velocity is not stable, and changes in monetary aggregates (especially the broader ones) are just as likely to reflect some non-monetary financial innovation as they are to reveal any deep macroeconomic trend.
More to the point, it’s not clear why monetary aggregates should be important for monetary policy. Aside from its ability to create cash, the Fed’s direct impact on monetary aggregates is supposed to come through reserve requirements: as the supply of bank reserves expands, banks can create more deposits. But this isn’t relevant at all for monetary aggregates larger than M1, since reserve requirements today only apply to checking deposits. Moreover, required reserves are only a tiny part of the monetary base, which (in normal times) consists almost entirely of cash. Since the monetary base is the quantity the Fed actually controls, any quantity-theoretic approach to conducting monetary policy must place most of its emphasis on the demand for cash, which plays a dominant role in the demand for base money in general.
Monetary aggregates like M1 do not do this. Instead, they treat checking deposits in exactly the same way as cash. If the two were obviously close substitutes, this might be forgivable, but in reality the demand for checking deposits and the demand for cash are quite different: the former is used to provide liquidity for general transactions, while the latter is used mostly to stash money for non-transactional purposes in the form of $50 or $100 bills, often outside the US.
Since the demand for base money is so difficult to predict (and monetary aggregates provide minimal guidance), the modern instrument for monetary policy is the short-term nominal interest rate. This instrument can be used in many different ways—for instance, to implement a Taylor rule, or maybe inflation targeting. But in the day-to-day conduct of monetary policy, it is essential, and monetary aggregates are meaningless.
This isn’t to say that monetary aggregates are completely uninformative: since they place such an emphasis on deposits, they do provide a useful picture of the banking system. It’s hard to imagine, however, that they provide a particularly effective way of capturing this information—after all, that’s not what they were designed to do.
I don’t claim to have any grand theory for why these ideas persist long after they have become academically and practically obsolete. It’s probably just inertia. But it is frustrating, and I hope that someday we’ll manage to make the conversation a little less outmoded.