Some people have impeccable timing. With the recent bout of high inflation, the commentariat is abuzz with possible explanations. Some have blamed supply chain disruptions, while others have attributed it to corporate greed. It seems most people want to blame inflation on anything but monetary policy. But finally, with the January release of Robert Hetzel’s “The Federal Reserve: A New History,” the adults have entered the room.
Monetary economists are often asked to discuss the stance of monetary policy. As Milton Friedman once lamented, this is harder than it sounds. While it is easy to identify the actions that policymakers are taking, it is much more difficult to describe their policy. It is this distinction that serves as the central theme of Hetzel’s book: What is the monetary standard? How might one describe monetary policy? How do we know if some central bankers are faced with turbulent times, or if their actions are actually the cause of the turbulence? Hetzel’s book is a tour de force, tackling questions such as these from the founding of the Federal Reserve (Fed) all the way through the COVID-19 pandemic.
The book is organized around a discussion of the monetary standard. What Hetzel means by the term is a systematic way of describing how the central bank behaves in response to new information, given its stated objectives. Evaluating the central bank’s actions and determining optimal policy requires some structural model of the economy. Hetzel’s hypothesis is that a monetary standard that produces price stability also generates macroeconomic stability by letting the price system adjust to allocate resources efficiently. Policymakers that do not follow rule-like behavior in pursuit of price stability cause macroeconomic instability. His history of the Fed is not only a historical account of the evolving nature of the Fed and its policy views, but it also serves as a test of this hypothesis.
The book succeeds in its mission because the history of the Fed is a testament to the strength of Hetzel’s hypothesis. When policymakers adopt nonmonetary theories of inflation, catastrophe results. Notably, Hetzel contrasts Fed policy under two different former chairmen: Arthur Burns’ nonmonetary view of inflation versus Paul Volcker’s view that the Fed was responsible for inflation. Convinced that inflation was caused by cost-push factors, such as pressure on costs from wage demands and other supply shocks, Burns was concerned that any attempt to fight inflation would cause high unemployment. Implicit in this argument is an assumed tradeoff between inflation and unemployment, which creates a role for activist management of aggregate demand, coupled with wage and price controls and a push for balancing the budget. The resulting period of stagflation demonstrated that no such tradeoff between inflation and unemployment existed.
The Paul Volcker-led Federal Reserve demonstrated the weakness of Burns’ arguments. Upon taking over as chair, Volcker took responsibility for inflation, and the Fed committed itself to a policy that Hetzel has termed “leaning against the wind with credibility.” This policy is a commitment to low, stable rates of inflation managed by responding to inflation expectations. By the 1970s, the expected rate of inflation had started to move in conjunction with actual inflation. Beginning with Volcker, the Fed took a preemptive approach and started responding to changes in expected inflation rather than actual inflation.
Rising inflation expectations led to tighter monetary policy. This commitment to rule-like behavior caused monetary policymakers to take actions that would prevent inflation from rising. By taking responsibility for inflation and preemptively acting to prevent high inflation from emerging, Volcker (and later Alan Greenspan) demonstrated the weakness of nonmonetary explanations of inflation and rendered it a waste of time to participate in Keynesian hand-wringing about disentangling demand-pull and cost-push factors.
This lesson is important to our current policy environment. Phillips Curve-like reasoning, which implies that there is a tradeoff between unemployment and inflation, or that inflation can only be brought down with rising unemployment, has returned to the meetings of the Federal Open Market Committee. The switch to a new regime of flexible average inflation targeting appears to be a significant departure from the monetary standard of Volcker and Greenspan and a return to the sorts of policies that characterized the 1970s.
Gone are the days of responding to changes in expected inflation to prevent inflation from rising. Gone are the days of the primacy of price stability with resource allocations determined by the price mechanism. Instead, the Fed has promised to respond to actual (rather than expected) inflation, with predictable results. The money supply grew at rates unprecedented in the postwar era in late 2020 and early 2021, and this has been followed by predictably high rates of inflation.
For readers of Hetzel’s book, one cannot help but see history repeating itself. As in the 1970s, our current moment is once again preoccupied with the causes of inflation and its macroeconomic effects. Like periods of high inflation in the past, there is no shortage of explanations. Economists seem determined to come up with unique and clever explanations for inflation, and financial journalists are all too eager to write stories about them. The “anything but monetary policy” explanation that plagued the Arthur Burns era of the Fed seems to be back in fashion.
For those infected by such brain worms, Hetzel’s book delivers an antidote. Cute and clever arguments cannot marshal a century of Federal Reserve history to their side, yet the monetary explanation can. Let’s just hope the antidote can reach the Federal Open Market Committee in time.