The Problem With Old-Style Monetarism

Summary

• While many conventional economists and market monetarists did not express much concern about inflation (until recently), more traditional monetarists like Bob Hetzel and Tim Congdon correctly warned that excessive money growth would trigger high inflation.
• Given the dramatic fall in immigration during Covid, the 1.56% RGDP growth is basically right on trend (per capita).
• The PCE index is up 5.73% from November 2020 to November 2021.

1001Love/iStock via Getty Images

This should be a time of celebration for monetarists. While many conventional economists and market monetarists did not express much concern about inflation (until recently), more traditional monetarists like Bob Hetzel and Tim Congdon correctly warned that excessive money growth would trigger high inflation. And yet I don't expect them to get much credit and I don't expect a revival of monetarism. To see why, let's look at the data:

Here I'd like to compare annual growth rates from 2019:Q4 to 2021:Q4:

Nominal GDP: +5.16%

PCE inflation: +3.33%

Real GDP: +1.56%

(They don't quite add up because I used the PCE inflation index that the Fed targets, not the GDP deflator)

M2: +18.8% (December 2019 to December 2021)

Given the dramatic fall in immigration during Covid, the 1.56% RGDP growth is basically right on trend (per capita.) But the relatively normal growth in RGDP actually reflects two rather dramatic shocks, which roughly offset each other:

1. Excessive growth in aggregate demand. Nominal growth should have been no higher than 4%/year and instead averaged over 5%. That pushed output above normal.

2. Supply chain problems related to early retirements and the switch from services to goods. That reduced output relative to trend.

These two factors roughly offset, leaving (per capita) output close to trend. The extra 1.16% in NGDP growth mostly led to higher than target inflation.

In some respects, the situation is even worse than these figures suggest. NGDP growth was at an annual rate of 14.3% in 2021:Q4, confirming that monetary policy in the second half of 2021 was far too expansionary, as many traditional monetarists claimed. I expect the overheating problem to get even worse in 2022, as NGDP growth is likely to continue running at a rate that is well above 4%. Monetary policy is still too easy.

So why won't monetarism make a big comeback? The problem here is that while monetarism was correct in a directional sense, the actual rise in inflation and NGDP was dramatically different from the growth in the monetary aggregates. (I used M2, but other aggregates also grew rapidly.) This reflects the fact that velocity slowed dramatically in 2020-21. M2 rose by over 41% over two years, while NGDP rose by barely over 10%. Thus, it is still true that monetary aggregates are not a reliable guide to monetary policy. To judge whether money is too easy or too tight, you need to look at expectations of NGDP growth.

Recent inflation figures look even worse. For instance, the PCE index is up 5.73% from November 2020 to November 2021. But that still means that someone who predicted 2% inflation this year was more accurate than someone who predicted 10% inflation. Is that how you think about forecast accuracy? Be honest.

I would call 2021 a marginal success for traditional monetarism. It supports the argument that the monetary aggregates provide some useful information that is not captured in conventional macro models. And while it's still early, I am pretty confident that 2022 will provide another marginal success for traditional monetarism. We are in for another year of high inflation. So don't take this post as a criticism of monetarism - its reputation should be higher today than a year ago.

Nonetheless, I don't see enough evidence to support the claim that the monetary aggregates can play a decisive role in policy formation - velocity is too unstable. Markets saw what happened this time, and I'd expect the next time we get a surge in the monetary aggregates, you'll see that data better incorporated into market forecasts. Markets will decide how much weight to put on the aggregates.

Market forecasts are still the best guide to policy. Recall that market forecasts were far more useful than the monetary aggregates during the Great Recession.

PS. Hypermind predicted 8.1% NGDP growth, whereas the actual figure was 11.7%, which represents a spectacular failure of the Hypermind market. (Hypermind forecasters implicitly expected Q4 NGDP growth of roughly zero, instead, it was 14.3%.) I suspect that there is a flaw in the way Hypermind reports its forecast, but I need to investigate further before I reach any conclusion. For the moment, I put more weight on TIPS spreads.

PPS. It's not clear why the economy overheated in late 2021, but I suspect one reason is that the Fed abandoned its FAIT regime. There doesn't seem to be any commitment to push inflation below 2%, as required by FAIT. Someone needs to ask Powell why that is.

PPPS. Greg Ip makes the common mistake of assuming that RGDP is a measure of aggregate demand. It isn't. Nominal GDP measures aggregate demand. (Consider RGDP and NGDP in Zimbabwe.) This leads him to wrongly conclude that the high inflation wasn't caused by excess demand. Supply problems certainly played a role, but so did excess demand.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Comments

[UK Lawman]

St Louis Fed gives Velocity of M2 for 2021 Q4 as 1.21. For decades it was c.1.8 and in 2009 was c. 2.0. This may explain why ‘new money’ has not increased inflation by much.

What are the probabilities for M2 falling even lower, or rising? And the consequences?

[Salmo trutta]

@UK Lawman Vi is a “residual calculation - not a real physical observable and measurable statistic.” I.e., income velocity, Vi, is endogenously derived and therefore contrived (N-gDp divided by M).

You would have to segregate and weight the various aggregates, like the Divisia Monetary Aggregates Index does, in order to determine monies impact.
centerforfinancialstability.org/...

“The summation index implies that all monetary components contribute equally to the money total, and it views all components as dollar-for-dollar perfect substitutes.” - Wikipedia

As Dr. Philip George says: “The velocity of money is a function of interest rates” and interest rates rose in the 4th qtr. What does that say about Vi?

[Salmo trutta]

What problem?

Monetary flows, volume times transaction’s velocity, proxy for inflation:

RE: “excessive money growth would trigger high inflation”

02/1/2020 ,,,,, 0.03 bottom
03/1/2020 ,,,,, 0.21
04/1/2020 ,,,,, 0.40
05/1/2020 ,,,,, 0.46
06/1/2020 ,,,,, 0.50
07/1/2020 ,,,,, 0.53
08/1/2020 ,,,,, 0.56
09/1/2020 ,,,,, 0.61
10/1/2020 ,,,,, 0.68
11/1/2020 ,,,,, 0.79
12/1/2020 ,,,,, 1.26
01/1/2021 ,,,,, 1.31
02/1/2021 ,,,,, 1.41
03/1/2021 ,,,,, 1.51
04/1/2021 ,,,,, 1.60
05/1/2021 ,,,,, 1.65
06/1/2021 ,,,,, 1.79
07/1/2021 ,,,,, 1.91
08/1/2021 ,,,,, 1.94
09/1/2021 ,,,,, 1.88
10/1/2021 ,,,,, 1.97
11/1/2021 ,,,,, 1.86
12/1/2021 ,,,,, 2.08
01/1/2022 ,,,,, 2.15 top (2yr roc)
02/1/2022 ,,,,, 1.71
03/1/2022 ,,,,, 1.44
04/1/2022 ,,,,, 1.40
05/1/2022 ,,,,, 1.35 bottom

[david.h.perrins]

@Salmo trutta what metric is this? MZM?

[Salmo trutta]

@david.h.perrins MZM is no longer reported.

[Salmo trutta]

In "Tight Money, Easy Money, and the New Economics”, August 1967, pg .135-137, by Leland J. Pritchard, Ph.D. Economics Chicago, 1933, M.S. Statistics, Syracuse, Dr. Pritchard elaborates.

He dissects the “credit school” and the “money school” and says: “With immaterial exceptions it may be said that as time deposit grow the primary money supply shrinks pari passu-unless offset by an expansion of bank credit.”…”Although increases in currency are always at the expense of demand deposits, either directly, or indirectly through the liquidation of time deposits, it cannot be said, as of time deposits, that increases in the public’s holdings of currency reflect prior commercial bank credit creation. It is more appropriate to say that expansions of currency are accompanied by concurrent expansions of Reserve bank credit”

“Unless Reserve authorities are desirous of following an easier or more restrictive monetary policy, any loss of bank reserves due to currency withdrawals from the banking system will be offset by an approximately equal volume of open market purchase of Governments for the portfolios of the Reserve banks”.

September 2020’s NSA M2 was reported as 14253.1. The figure was not exceeded until September 2021 @ 14,377.3. M2 has then exploded in the 4th qtr. until December 2021 @ 14,737.7. M2 grew by 516.6 in the 4th qtr. DDs have grown by 353.4, and currency by 30.7. Thus, the overall money stock grew by 900.7.

Currency was previously, prior to Covid-19, a fraction of DDs @ .907 in FEB 2020. Now currency is a multiple of DDs @ 2.291. I.e., the cashing of time deposits has greatly increased our “means-of-payment” money supply.

[david.h.perrins]

@Salmo trutta credit crunch?

[Salmo trutta]

@david.h.perrins Just the opposite. Currency turnover is about the same as DDs.

[david.h.perrins]

@Salmo trutta DDs being demand deposits, please define "Currency Turnover"

[Salmo trutta]

RE: “Thus it is still true that monetary aggregates are not a reliable guide to monetary policy.”

“The Fed’s favorite inflation indicator – Core PCE Deflator – surged more than expected to +4.9% YoY, its highest since April 1983…”

This fits my modeling, the monetarist's distributed lag effect of money flows. The price indices, reported in FEB, peak with JAN's figures.

The cash-drain factor, the ratio of currency to demand deposit accounts, has increased from .667 in January 2000 to 2.301 in December 2021. Ergo, more currency is being used to support higher prices.

The 4th qtr. 2021 increase in R-gDp of 6.9% can only be explained by the surge in currency during the 4th qtr. (by the cashing of time deposits, or by the temporary acceleration in velocity).

RE: “To judge whether money is too easy or too tight you need to look at expectations of NGDP growth.”

The composition of money has changed. And the velocity of money has changed. But you can’t look at N-gDp growth with just one rate of change in the monetary aggregates.

[david.h.perrins]

@Salmo trutta go on...

[Pompano Frog]

Dear Reader..

The reason the FRB engaged in expansionary monetary policy in the face of a massive financial market bubble is their desire to not tank the equity markets. They are well aware that when the equity markets collapse you have a recession and the existing political parties in power are hurt. See Ben Bernanke "The Financial Accelerator Model."

Western academics and those they influence have a number of core beliefs that have no basis in reality and lead to poor decision making outcomes. One of those is expressed here:

"Markets saw what happened this time, and I'd expect the next time we have a surge in monetary aggregates, you'll see that data better incorporated into market forecasts."

Nothing could be further from the truth. This does not take into account that decision makers use a process where those decisions are made to further their careers and represent the perceived interests of their institutions. Now, to quote from Billions, those interests usually coincide, but when they don't the public interest or the investor's best interest are meaningless.

As Grantham says on his interview this weekend on Bloomberg. A must see, by the way. Wall Street institutions never..never blow out a positive forecast on markets. It's not good for business. It's not good for client retention. Win or lose, clients don't like to hear negative news.

The members of the Federal Reserve Board are political. They are subject to spoken and unspoken threats. They, correctly, see their future careers benefiting by attempted defense of the existing political majority. Wait until we near the November election and you will see an enormous willingness to increase tightening with the hope the ensuing chaos will be blamed on the change in political regime.

I hold no U.S. equities. See previous comments for ideas on how to deal with this environment and/or look at my comments from 2009/2010. They are enlightening.

S&P 4431, Nasdaq 13770, Russell 2000 (IWM) 195.25