Is monetarism making a comeback?

Dennis Robertson, the late Cambridge economist, was fond of saying that economic fashion was like going to the greyhound races. If you stood still long enough, the old dogs would come around one more time.

We have to wonder whether the same might be said of Milton Friedman’s fundamental view of inflation. Friedman famously said that inflation is always and everywhere a monetary phenomenon. He made this statement in his belief that inflation is and can be produced only by a more rapid increase in the quantity of money than in output.

In the inflationary environment of the 1970s, Friedman’s ideas gained widespread support among economists. They did so to the point that many central banks, including the Federal Reserve, engaged in monetary aggregate targeting to achieve their inflation objectives. But when such targeting failed to deliver the desired inflation result, monetary targeting was abandoned to the point that central banks stopped publishing monetary aggregate data.

Supporting the central banks’ abandonment of monetary targeting is what is called “Goodhart’s law,” propounded by Charles Goodhart, a former senior Bank of England official. According to that law, any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

Fast forward to today, and the monetarists would seem to be making a comeback. Last year, when much of the economic profession failed to anticipate a surge in inflation, the monetarists were warning of a return of inflation to levels last seen in the early 1980s. They were doing so based on the 40 percent surge in the broad money supply that the Fed allowed in the two years immediately following 2020’s COVID-19-induced recession. In the event, U.S. inflation surged to a 40-year high of over 9 percent. It did so with the lag that the monetarists predicted.

Now the monetarists are making another bold call. They are suggesting that U.S. inflation will come down sharply and the economy will have a hard economic landing within the next year. In their view, it will do so in a lagged response to the recent collapse in the money supply.

In support of their argument, they are pointing to the fact that after having allowed the broad money supply to grow by over 25 percent at an annual rate in 2022, the Fed has now caused the broad money supply to contract from last year’s level. It has done so by slamming the monetary policy brakes on hard to regain inflation control. The resulting contraction in the broad money supply has not occurred previously in the past 60 years.

But if inflation comes down sharply over the next year, it won’t mean we should all become monetarists. It will be possible to also explain any future sharp drop in inflation by the fact that over the past year interest rates have been increased at their most rapid rate in the past 40 years. They have also been increased while the Fed has been engaged in an unprecedented pace of quantitative tightening at the pace of $95 billion a month.  

The Fed’s recent failure to anticipate multi-decade high inflation should induce it to be humbler in its policymaking decisions. At a minimum, rather than relying solely on its Keynesian-inspired macro-economic model, it should also keep an eye on the wild swings that it is causing in the monetary aggregates. Those aggregates might serve as an additional leading indicator of where inflation and the economy might be headed, as the monetarists are now claiming.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.