Friday , October 30 2020
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A win for monetarism?

Summary:
Later on, I’ll have more to say about the Fed’s new approach to policy, but this portion of Jay Powell’s speech caught my eye: [O]ur revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation. In earlier decades when the Phillips curve was steeper, inflation tended to rise noticeably in response to a strengthening labor market. It was sometimes appropriate for the Fed to tighten monetary policy as employment rose toward its estimated maximum level in order to stave off

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Later on, I’ll have more to say about the Fed’s new approach to policy, but this portion of Jay Powell’s speech caught my eye:

[O]ur revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.

In earlier decades when the Phillips curve was steeper, inflation tended to rise noticeably in response to a strengthening labor market. It was sometimes appropriate for the Fed to tighten monetary policy as employment rose toward its estimated maximum level in order to stave off an unwelcome rise in inflation. The change to “shortfalls” clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals.

Keynesians have traditionally held a “Phillips Curve” model of inflation.  They believe that inflation is caused by a very strong job market.  In contrast, monetarists have argued that inflation is caused by excessive money printing and that economic growth is actually deflationary, ceteris paribus.  Henceforth, the Fed will abandon Phillips curve models and instead look for “signs of unwanted increases in inflation”.  To older monetarists, that would be excessive money supply growth.  To market monetarists, that would be a rise in market forecasts of inflation.

I don’t believe the Fed will pay much attention to the monetary aggregates when forecasting inflation, as old style monetarism did not perform well during the Great Recession.  I also see this statement as an implicit rejection of the Keynesian approach to inflation forecasting, which failed in the late 2010s, and a tacit acceptance of the market monetarist approach, which was more successful during the late 2010s.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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