That is the key – and unassailable – tenet of monetary theory.
The corollary is that the fiscal policy’s long-run impact on economic activity is zero, or even negative.
The rejoinder, offered by the British economist, John Maynard Keynes, the proponent of government spending (to fill the void of the weakening household consumption, business and residential investments), was that “in the long run we are all dead.”
Predictably, monetarists labeled the Keynesian view as pure politics, with no relevance to the theory of economic policy.
We are still there, although those debates date as far back as WWI (sic) war reparations, Britain’s return to the gold standard in 1925, the Bretton Woods Conference in 1944, and the monetarists’ ongoing assault on central banks’ zero and negative interest rates.
And here is a question: Is that monetary-fiscal controversy relevant to the policy response after the current flare-up of American inflation pressures?
Price stability is a public good
The answer, of course, is a resounding “yes.” The monetary theory is correct. There should be no equivocation about that. And the empirically grounded principles of monetary theory should not be confused with uncertainties the actual monetary policy has to deal with.
So, here is a practical policy issue: What can the U.S. Federal Reserve (Fed) do in a situation where it allowed inflation to accelerate from 1.4% to 7% in the course of 2021?
The Fed has no choice. It is staring at an inevitable economic recession that will erase the fiscal stimulus and further aggravate America’s precarious public finances.
Let’s start with the obvious. Such strong, and broad-based, inflation dynamics cannot be stopped, and reversed, without a significant, and sustained, decline of cost and price pressures in U.S. labor and product markets.
Can the Fed do that without causing a deep and protracted growth recession?
The answer is that a probability of such an outcome is zero, or very close to zero.
Trying to determine the correct policy, the Fed is facing two big unknowns: (a) it does not know exactly where the economy is when it calibrates the extent and the pace of monetary restraint, and (b) it knows even less where the economy will be three or four quarters hence, when higher, and rising, credit costs begin to depress economic activity.
And that leads to an empirically proven policy conclusion: Inflation is a result of a monetary stimulus maintained past the point where the economy needs it; conversely, recessions occur when the monetary restraint continues past the point where it is needed to slow down the economic activity.
We then have a logical call from die-hard monetarists: If you don’t know those two essential conditions for your policy settings (points (a) and (b) above), stop destabilizing the economy with wrong policies.
Recession in a structurally weak economy
Their advice, based on a Nobel Prize winning research, is quite simple: Set the money supply growth at a rate compatible with a sustainable price stability – and keep it there, ignoring short-term price and activity fluctuations. [Milton Friedman, the key proponent of monetarism, was awarded the 1976 Nobel Memorial Prize in Economics for his “contribution to … monetary history and theory, including his observations of the complexity of stabilization policy.”]
The monetarists’ advice was caricatured as an automatic pilot that would abolish the discretionary monetary policy. Ron Paul, a Texas Congressman, even published a book “End the Fed” that hit The New York Times bestseller list in 2009.
It is true that the Fed must operate with ex-ante unknowable variables, but it is also true that the Fed does not have to fly blind in its credit policy decisions. The Fed should not have ignored last year’s sharply accelerating inflation, confirmed by its own data – the “beige book” business surveys – that provide the key input to its interest rate deliberations.
So, what now?
Having acknowledged that its forecast of a “transitory and reversible” inflation was incorrect, the Fed has recently announced interest rate increases and money supply contractions for later this year (after mid-term Congressional elections in early November?).
It also looks like the Fed is expecting that the raging pandemic, and the soaring trade deficits, would depress inflation and economic growth in the coming months.
That is possible, but the Fed will still have to make decisions on the extent and frequency of interest rate increases in the context of its own short-term forecasts of demand and supply conditions in labor and product markets.
That is a tough call. The Fed is dealing with a very fragile economy beset by deep-seated structural problems. Chief among them are labor supply shortages (with 40% of the civilian population out of the labor force), excessive budget and public debt deficits (12.4% of GDP and 127% of GDP, respectively), and a net foreign debt of $16.1 trillion (70% of GDP).