I found this article published on the AIE site, Jay Powell ignores Milton Friedman at his — and our — peril, by Desmond Lachman, a former economics strategist at the International Monetary Fund. I was about to take issue with what it says with all barrels blazing, but because it discusses Milton Friedman specifically without providing any quotes or references, I thought I’d take a closer look at what Friedman actually said in relation to the ideas in this article before jumping in.
Here is Lachman:
Milton Friedman, the great scholar of U.S. monetary policy history, never tired of reminding us that monetary policy operates with long and variable lags.
By this he meant that raising interest rates does not have an immediate impact on the economy. Rather, it takes a long and uncertain time before Federal Reserve policy tightening influences the economy.
Jay Powell, the new Federal Reserve chairman, would do well to heed Friedman’s basic teaching in his efforts to keep inflation from exceeding the Fed’s 2-percent inflation target.
In particular, he would be well advised not to wait for clear signs of inflation to emerge before he has the Fed move to a more restrictive monetary policy stance than it is presently pursuing.
If he waits for inflation to reach the Fed’s target before acting, he will have waited too long and the Fed would be almost certain to miss its inflation target given the long lags with which monetary policy tightening works.
Of course this is taking one sentence Friedman uttered about lags and building his own speculative strawman on top. Friedman never said inflation that slightly exceeds the target is harmful, and I’d challenge Lachman to find any paper in which Friedman made such a claim. And I think here, too, is a misunderstanding of the target itself because Lachman brings up inflation expectations while nearly all of these measures encompass expectations of CPI when the Fed’s target is PCE.
The latest consumer price numbers show that headline inflation is now running at 2.1 percent while core inflation has now reached 1.8 percent. Meanwhile, long-run inflation expectations, as measured in the 5-year bond futures market, has now risen to 2.2 percent or significantly above the Fed’s inflation target.
For the sake of argument, assuming that the CPI is the Fed’s target, I wonder why 2.2% inflation on the CPI is assumed to be “substantially above target” when 1.5% isn’t not substantially below. What, if anything, does Lachman believe should be done about below target inflation? Since we supposedly have long and variable lags, which implies some lack of precision, wouldn’t inflation that hovers around the target, some of the time a little below and sometimes a little above be expected in a healthy setting? These are important points in understanding how the target works because in addition to stating that its target is PCE, the Fed has also stated in nearly every statement released over the last few years that its target is symmetrical, meaning that it is not a ceiling and will average 2% in the medium term. Lachman appears to be confused on this point.
A paper I found from the St. Louis Fed that contains some discussion of Milton Friedman’s scholarship on the matter of inflation has the following quotes:
As Friedman emphasized, “Inflation is an old, old disease. We’ve had thousands of years of experience of it. There is nothing simpler than stopping an inflation—from the technical point of view.”1
That remedy took a specific form: “The only cure for inflation is to reduce the rate at which total spending is growing.” This cure involved a temporary side effect, as Friedman noted: “There is no way of slowing down inflation that will not involve a transitory increase in unemployment, and a transitory reduction in the rate of growth of output. But these costs will be far less than the costs that will be incurred by permitting the disease of inflation to rage unchecked.”
About inflation, Friedman says:
“The only cure for inflation is to reduce the rate at which total spending is growing.”
It is important to think about what reducing the rate total spending is growing means. It doesn’t mean rate hikes. In understanding what Friedman said, it is helpful to think about the equation of exchange, M*V = P*Y which can also be expressed this way: M*V=NGDP. He was talking about M, the growth rate of the base, implying a reduction in both the growth of prices and income/output, or total NGDP.
He thought doing this was more appropriate than what was then being done:
“There is no way of slowing down inflation that will not involve a transitory increase in unemployment, and a transitory reduction in the rate of growth of output. But these costs will be far less than the costs that will be incurred by permitting the disease of inflation to rage unchecked.”
This is where the context of the time is important to understanding the reasoning. The Fed, at the time, had an implicit unemployment target and thus was “permitting inflation to rage unchecked”, whizzing mostly up but also down like fireworks at a carnival – high and unstable – which IS harmful.
Compared to the time we are living in where inflation is both low and relatively stable, because of the consequences involved in reducing inflation as outlined by Friedman, with very little upside for the average investor because both prices and output/income are reduced, it would be irresponsible to look at the expectation of 2.1% CPI showing in the TIPS spreads, conclude that inflation is “raging unchecked” – neither low nor stable, and advocate a disinflation. There is absolutely no way this could pass a welfare cost/benefit analysis.
My interpretation of this article is that Mr. Lachman is advocating that for 0.1% above 2% on the CPI, every last person with dollar-denominated interests needs to take an income hit, without accounting for the Fed targeting the PCE index in a symmetrical fashion, not the CPI as ceiling, a target that the Fed has been undershooting for nearly a decade.
If Mr. Lachman believes inflation expectations have anything at all to do with current market volatility, what does he believe a negative nominal shock would do for markets, or how well controlled such a disinflation might be in the current situation of an IT regime that is well understood to be biased toward tight that has too many moving parts?
It is sincerely my opinion that Mr. Lachman has a lot more work to do before attaching Friedman’s name to his own ideas.