Milton Friedman Luncheon, University of Missouri-Columbia, Columbia, Mo., July 31, 2007Money supply ; Friedman, Milton

William Poole

English

Research Papers in Economics

1
Milton and Money Stock Control
Milton Friedman Luncheon
Co-sponsored by the Department of Economics, University of Missouri,
the Economic and Policy Analysis Research Center, and the Show-Me Institute
University of Missouri–Columbia
Columbia, Missouri
July 31, 2007
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their com-
ments, but I retain full responsibility for errors.
THE CASE FOR MONEY STOCK
CONTROL
As a card-carrying monetarist, I argued the
steady money growth case vigorously in years
past, and it is still my conviction that a central
bank ignores money growth at its peril. Milton
and his co-authors, especially Anna Schwartz,
provided ample evidence that variations in money
growth were highly correlated with the business
cycle, and he argued that steady money growth
would reduce the amplitude and frequency of
recessions. He also argued that sustained infla-
tion would be impossible without sustained
money growth in excess of the economy’s long-
run real rate of growth.
Milton favored steady money growth because
he did not believe that central bankers were wise
enough to improve on the outcomes that would
flow from steady money growth. With evidence
from the Greenspan era, Milton changed his view
a bit, but was not convinced that Greenspan’s
success in adjusting the stance of monetary policy
was likely to be replicated by future Fed chairmen.
The case for controlling the money stock also
rested on the dangers of controlling interest rates.
W
e are here today on Milton
Friedman’s birthday to remember
him and his enormous contribu-
tions. Those of us who studied
under him are extraordinarily fortunate. Most of
us were able to maintain contact with him for
the years between our studies and his death.
If Milton were here today there is nothing he
would enjoy more than a lively seminar on some
aspect of economics. A lively seminar is what I
intend to offer. I’m pretty sure that what I’m going
to say would have provoked him and that I would
have learned a lot from hearing him comment on
my analysis.
Of the monetary economics battles Milton
fought in the 1960s and 1970s, his policy prescrip-
tion for steady money growth at a low rate is the
only important issue where he failed to carry the
profession. Mainstream macroeconomics accepts
his view that the long-run Phillips curve is verti-
cal, that we need to focus on real, rather than
nominal, interest rates, that low inflation is central
to economic stability and that fiscal policy has
little to do with short-run fluctuations in employ-
ment and output. But few economists still support
money growth targeting.
Although Milton’s money-growth policy
prescription did not win out, I believe that his
analysis justifying this prescription has had much
more influence than many realize. I’ll review his
case for this recommendation and then discuss
how this case relates to current central bank
practice.A policy interest rate held too low set in motion
a cumulative process of larger and larger infla-
tionary disequilibrium; with a pegged nominal
rate of interest, rising inflation and inflation
expectations would lower the real rate of interest.
That was the opposite of what would be needed
to quell inflationary fires. The process was sym-
metrical; with ongoing deflation, a monetary
policy holding a nominal interest rate steady
would promote deflation and a rising real rate of
interest. An adjustable interest-rate peg does not
change the analysis in any fundamental way;
given that inflation expectations may be changing,
the issue remains whether interest-rate adjust-
ments are adequate to move the real rate of inter-
est in the appropriate direction. Steady money
growth, on the other hand, was inherently stabi-
lizing as the real rate of interest would tend to rise
during an inflation and fall during a deflation.
Milton also argued for steady money growth
on political grounds. A commitment to steady
money growth would reflect a rule of law rather
than of men. He did not trust the legislature to
run monetary policy in a nonpolitical way, nor
did he trust “unaccountable bureaucrats,” as he
might put it, appointed for long terms to conduct
a discretionary monetary policy. His view was
shaped by the Fed’s poor performance in the early
years of the Great Depression and by the fact that
at that time pressure from Congress, when it was
in session, did push the Fed a bit in the correct
direction.
This background is all familiar ground; I
review it to introduce my comments on current
central bank practice.
CONSEQUENCES OF
CONTROLLING THE FEDERAL
FUNDS RATE
Everything Milton argued about money stock
control is true, but the effect of inflation expecta-
tions on the practice of monetary policy itself
was, I believe, a missing element in the analysis.
The economy functions differently when inflation
expectations are firmly anchored. If a central
bank allows expectations to become unanchored,
then interest-rate control becomes a dangerous
and potentially destabilizing policy. But should
the practice of monetary policy depend on how
well inflation expectations are anchored? I do
not recall Milton discussing this question, per-
haps because he believed that the best way to
maintain well-anchored expectations over time
was for the central bank to commit to steady and
low money growth under all circumstances.
How does a central bank anchor inflation
expectations? One approach would be for the
central bank to commit to low and steady money
growth come what may. A problem with this
approach is that it may not appear credible to
the markets when financial instability and/or
recession occurs. If a policy of steady money
growth has exceptions, can the exceptions be
defined in such a way to retain anchored infla-
tion expectations?
A necessary and sufficient condition for
anchoring is that the central bank act vigorously
to resist inflation or deflation whenever it becomes
evident and particularly when inflation expecta-
tions change, up or down, in an unwelcome way.
If the central bank is willing to push as hard as it
takes, regardless of short-run consequences to
unemployment and especially to the bond and
stock markets, then market participants will
develop firm views on the likely rate of inflation
in the future. The Fed must convince market
participants who bet against it that they will
regret their bets.
It is highly desirable that the central bank
behave in a rule-like way, both for the political
objective of the rule of law rather than the rule of
men and because predictable policy promotes
more efficient decisions in the private sector. To
the maximum possible extent, we desire an equi-
librium in which the markets behave as the central
bank expects and the central bank behaves as the
markets expect. Central bank behavior to anchor
expectations of low and stable inflation is the
single most important aspect of policy predictabil-
ity. I believe that the Fed has come a long way in
that direction though, obviously, there are cer-
tainly opportunities for the Fed to refine its policy
MONETARY POLICY AND INFLATION
2rule. In this context, by “rule” I simply mean that
the Fed’s policy actions are systematic and highly
predictable responses to new information.
Steady money growth would also be highly
predictable, but I believe that the Fed’s actual
adjustments of its federal funds rate target have
yielded superior outcomes since 1982 to what
we would have observed under steady money
growth. I also believe that advances in knowledge
permit us to say with some confidence that these
gains are not just an accident of Alan Greenspan’s
special skills and intuition.
So, the Fed has pushed hard at certain times,
and kept its federal funds target unchanged at
other times, with the result that inflation expec-
tations are now quite well anchored and policy
adjustments are not themselves disturbances to
the market. With inflation expectations anchored,
changes in the nominal federal funds rate reliably
move the real federal funds rate in the same direc-
tion and by roughly the same amount. Data from
trading in indexed Treasury bonds, and from
surveys, allow the Fed to monitor changes in
inflation expectations continuously. Such moni-
toring helps tremendously to provide assurance
that the Fed is not falling behind in its policy
adjustments.
I noted that an attractive part of the case for
steady money growth was that market-driven
changes in interest rates would be inherently
stabilizing. Interestingly, and I think surprisingly,
we now see the same process at work with longer-
term bond yields. The Fed adjusts its federal
funds rate target in a discretionary, though highly
predictable, fashion, but significant changes in
long rates do occur. Those of you who follow the
markets closely could point to many cases in
recent years in which long rates have helped to
stabilize the economy while the Fed remained
on the sidelines, holding the federal funds rate
target unchanged.
We are witnessing this phenomenon currently.
Putting aside what is happening to the markets
as I speak—something I obviously could not
incorporate in my written text—the decline in
long Treasury rates last week surely helped to
stabilize markets relative to a situation in which
those interest rates were held fixed by monetary
policy. If the Fed had been pegging long rates, the
flight to quality last week would have required
the Fed to take funds out of the market. That
would have been a destabilizing response to
market fears concerning housing and the sub-
prime mortgage market. Nor would the Fed have
been in a good place if it had to make a decision
as to just how far it should adjust a pegged long
interest rate. This is the kind of judgment best
left to the market.
What our analysis missed a generation ago
was that the typical model with only one inter-
est rate could not possibly allow for stabilizing
market responses in long rates when the central
bank set the short rate. Of course, macro econo-
metric models did have both short and long
rates, but the structure of the models did not per-
mit analysis of the sort I am discussing because
the typical term structure equation made the
long rate a distributed lag on the short rate. The
model’s short rate, in turn, was determined by
monetary policymakers setting it directly or by
the money market under a policy determining
money growth.
Once we allow expectations to uncouple the
current long rate from the current short rate, the
situation changes dramatically. The market can
respond to incoming information in a stabilizing
way without the central bank having to respond.
Long bond rates can change, and change substan-
tially, while the federal funds rate target remains
constant.
Eventually, of course, if changed conditions
persist, the central bank will have to adjust the
policy rate in the direction required by the new
information. In the absence of such eventual
policy adjustment, the destabilizing effects of a
constant interest rate emphasized in the earlier
literature will appear.
THE BOTTOM LINE
Consider where this analysis leaves us.
Assume inflation expectations are well anchored.
The central bank can hold its policy rate relatively
Milton and Money Stock Control
3steady and rely on market adjustments in long
rates to do much of the stabilization work. When
new information arrives, most of the time the
central bank can wait for market responses and
the passage of time to clarify what is happening.
The current situation is a perfect illustration.
The Fed doesn’t know and market participants
do not know either, the full implications of last
week’s stock market declines and increases in
risk spreads. Market reactions last week may be
overdone, or perhaps not. We just do not know.
In a situation like the terrorist attacks of 9/11,
the Fed knew enough to believe that a quick pol-
icy response would be helpful and unlikely to
itself be destabilizing.
A typical market upset, such as last week’s,
is not at all like 9/11. Most of these upsets stabi-
lize on their own, but some do not. I’m not saying
that the Fed should ignore what happened last
week—we need to understand what is happening.
However, it is important that the Fed not permit
uncertainty over policy to add to the existing
uncertainty. The market understands, I believe,
that the Fed will act in due time, if and when
evidence accumulates that action would be appro-
priate. That is why trading in the federal funds
futures market reflects changed odds from two
weeks ago on a policy adjustment later this year.
If last week’s events do not turn out to change
the probable course of economic growth and
inflation, then the fed funds futures market will
reverse course and the expected policy easing
will disappear. Or, if evidence accumulates that
the inflation picture remains benign but the out-
look for the economy next year appears likely to
be significantly weaker than the current best
guess, then the market will deepen its conviction
that the Fed will be cutting its fed funds target.
The regularity of Fed behavior I espouse is
that the Fed should respond to market upsets
only when it has become clear that they threaten
to undermine achievement of fundamental objec-
tives of price stability and high employment, or
when financial-market developments threaten
market processes themselves. The Fed should not
try to substitute its judgments for the market’s
judgment on appropriate security prices. The
right question to ask is not whether Fed action in
response to any current market upset would be
desirable but rather whether it is possible to
define a systematic response to market upsets in
general that would be helpful. The answer I give
is that effects on the economy can rarely be under-
stood without passage of time and more informa-
tion. Occasionally, there is contemporaneous
evidence of damage to market mechanisms that
might justify quick Fed action.
The key point is that, in these situations, the
market is making judgments on security prices,
stabilizing the economy without the Fed having
to lead the way. This is exactly the process envi-
sioned a generation ago by the monetarist advo-
cates of steady money growth. This is what Milton
taught us about markets, and he was right.
When inflation expectations are firmly
anchored, an important reason for the Fed to let
markets take the lead is that overactive Fed
responses to market developments set precedents
that tend to destabilize markets in the future. If
the market believes that the Fed is always primed
to adjust policy, then market participants will
spend more time trying to second-guess the Fed
than trying to understand what is happening to
business and household behavior. As I empha-
sized earlier, a good market equilibrium requires
that the Fed behave as the market expects. When
there are widely varying interpretations in the
market about what is happening, it is impossible
for the Fed to behave as the market expects
because there is no unified view in the market
about what is happening. At any given time, it
may be impossible for the market to come to a
unified view about what is happening, simply
because of incomplete knowledge and different
professional judgments by those best informed.
Still, there need be little or no uncertainly about
Fed behavior the day before an FOMC meeting.
Fed actions at future meetings months ahead
will remain uncertain, to both the market and
the FOMC itself, because the future information
set is uncertain.
In the meantime, the central tendency of
market views on what is happening will control
the long bond rate and security prices more gen-
MONETARY POLICY AND INFLATION
4erally. Differences in market views as to what is
happening will determine who is long and who
is short in the market. Eventually, as new infor-
mation clarifies the situation, the variance of
views around the central tendency will fall and
more normal market conditions will reemerge.
As for the politics of monetary policy, I
believe there is extremely wide support for a
totally apolitical Fed. There is a consensus on
the desirability of low inflation and that the Fed
should do what it can to stabilize the unemploy-
ment rate at the lowest rate consistent with sus-
tained non-inflationary economic growth. The
market and most political leaders believe that
the Fed is apolitical. The market trusts us, and
we, in turn, work hard to retain this trust. When
I say “we” I really mean the Fed as an institution.
Fed officials, staff and Reserve bank directors
have a deep understanding of the importance of
apolitical monetary policy. This understanding
goes far toward making Fed actions reflect a rule
of law rather than a rule of the individuals making
the decisions. The closest analogy, perhaps, is
that we work as fiduciaries. I do not deny that it
would be desirable for the Federal Reserve Act
to be clearer about the objectives the Fed should
pursue. Still, the Fed as an institution has gone a
long way to make its policy actions rule-like in
their regularity. If the institution is strong and
incorruptible, as I believe it is, then we probably
have as much assurance in a democratic society
as we are likely to get.
Although Milton did not prevail in his quest
to have the Fed maintain a constant money growth
rate, he did prevail in his insistence that policy
be apolitical and rely to the maximum possible
extent on market judgments. He lost a battle but
truly did win the war.
Milton and Money Stock Control
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Milton and money stock control

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