Our monetary Rube Goldberg device

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John Cochrane raised some difficult questions in the comment section of my previous post. I replied to his comment and also promised to give a more complete reply in my next post (i.e., this one). John responded with a briefer comment, which gets at the heart of the problem:

I agree that if the Fed controlled M, and if M were different from B [bonds], then reducing M raises interest rates. But here's the key question: Our Fed targets an interest rate. It does not control money supply at all. Does setting an interest rate determine the price level, and if so how? MV(i) = PY. Set i, that sets V, ok. But the same V is consistent with any level of M, and any level of PY. The doctrine "an interest rate target is not enough to determine the price level" seems a core of monetarism. Monetarists answer "control the money supply." Maybe the Fed should. But the Fed doesn't. So what theory do we use to understand the price level in our world? FTPL does the trick, of course.

I’m in the difficult position of defending a proposition while hating the background apparatus that makes the proposition valid. The proposition I defend is that the Fed can and should control nominal aggregates such as the price level or NGDP, and the background apparatus that I hate is interest rate targeting, which I view as making monetary policy both less effective and more confusing. It makes a policy tool (the monetary base) that is in an important respect exogenous look like it is endogenous. In this post I’ll try to explain why our convoluted monetary system seems to work, despite the fact that in some ways it looks like it should not work.

I’ll create an imaginary dialogue with a skeptic of monetarism. I intend some (not all) of the skeptic’s comments to represent something vaguely like Cochrane’s views, but I won’t put words into his John’s mouth—I’ll just call him “skeptic”. I will start with the basics to avoid any confusion. I apologize if some of this is obvious:

Me: Prior to 2008, the Fed mostly controlled the price level by adjusting the currency stock. If they wanted 2% inflation, they increased the nominal currency stock at a rate 2% faster than growth in real currency demand.

Skeptic: Actually, the currency stock is demand determined. The Fed supplies whatever quantity of currency the commercial banking system requests, freely exchanging reserves for currency.

Me: Yes, but prior to 2008, banks held only very small quantities of reserves balances at the Fed, about 2% of the monetary base. So as a practical matter the Fed could control the currency stock by adjusting the total monetary base through open market operations. And prior to 1913, there weren’t any deposits at the Fed—the base was 100% currency. They even had ultra-high denomination currency notes for the big NYC banks to hold as reserves:

I think of zero interest reserves as being functionally equivalent to cash.

Skeptic: Even so, the monetary base as a whole was also endogenous, as even before 2008 the Fed engaged in interest rate targeting. The Fed must supply base money as required to stabilize the fed funds rate at the Fed’s target. And Milton Friedman showed that if they do that, then the price level is indeterminate.

Me: I agree, but it is misleading to say the Fed targets interest rates. After all, they also target inflation. And you cannot hit two targets with one instrument. This paradox is resolved if we assume the Fed targets interest rates over relative short 6-week intervals and then adjusts the interest rate target as required to keep inflation on target over a longer period.

Skeptic: OK, but how does the interest rate targeting system stabilize inflation? Keynesians tell us that high interest rates are the key to reducing inflation, but the Fisher effect suggests that high interest rates are likely to be associated with high inflation.

Me: I agree, that’s why I hate interest rate targeting. But New Keynesians insist it can be done, and they may be correct. They assume there is an (unobservable) equilibrium interest rate that would provide macroeconomic stability. When the Fed sets the target interest rate above that equilibrium rate you have tight money, which reduces inflation. When the Fed sets the policy rate below the equilibrium rate, inflation rises.

Skeptic: But all through the late 1960s and much of the 1970s, the Fed repeatedly raised interest rates, and yet inflation kept getting worse.

Me: (Visibly frustrated) Yes, that policy didn’t work very well. That’s why Milton Friedman didn’t like interest rate targeting, nor do I. The Fed was often behind the curve, raising rates more slowly than the equilibrium interest rate was rising. Why was the equilibrium rate so high? Because the Fed printed lots of money in the 1960s and 1970s, causing high inflation. The Fisher effect. That’s the specific sense in which monetarists believe interest rate targeting doesn’t work very well. It’s a clumsy tool.

Eventually, things got so bad the Fed started listening to Friedman almost out of desperation. In 1979, they stopped targeting interest rates and started directly slowing the growth in the money supply.

Skeptic: But money supply targeting didn’t work and was dropped in 1982. Velocity was unstable.

Me: Define “didn’t work”. Yes, in the end it looks like money supply targeting at a fixed growth rate is not optimal. Friedman was wrong about that. But the policy of reducing money growth did sharply reduce inflation in 1981-82 (despite Reagan’s big budget deficits), indeed much more dramatically than even Paul Volcker expected. Inflation reduction was the whole point of money targeting, and on that score it was a big success. And even if velocity is unstable, you can still use money as a policy instrument, as long as you adjust the monetary base to offset money demand shocks.

The money targeting period (1979-82) demonstrates that the Fed can make money exogenous if it chooses to. It doesn’t have to target interest rates.

Skeptic: But the Fed went back to interest rate targeting in 1982; doesn’t that mean that money is once again endogenous?

Me: Whether something is endogenous or exogenous entirely depends on one’s frame of reference. In the very short run, the monetary base is endogenous under interest rate targeting. But over a time frame of macroeconomic significance (months and years), I’d argue that the base is essentially exogenous. Even after 1982, the Fed was—at the most basic level—controlling inflation by controlling the growth rate of the base. Yes, it doesn’t look that way. It’s such a Rube Goldberg device that it looks to almost everyone as if money no longer plays any role in monetary policy.

Skeptic: Please explain.

Me: After 1982, the Fed adopted the Taylor Principle, moving interest rates up and down aggressively enough to avoid the mistakes of 1966-81 (until 2021-22, when they foolishly ignored warning signs.) To most of the world, it looked like the Fed was controlling inflation by manipulating interest rates. But to a monetarist, at a deeper level the Fed was controlling inflation by adjusting the interest rate target in such a way as to produce a money supply growth rate that was consistent with 2% inflation.

During 1982-2008, it looked like interest rates were determining M, but to a monetarist it was the exact opposite. The Fed’s New York desk was told to adjust the base (M) in such a way that the fed funds rate is on target. M determined i, at a level where the Fed wanted i to be. The Fed assumed a correct “i” was stabilizing the economy, whereas monetarists believe it is a correct “M” that stabilized the economy.

[It would be like OPEC leaders arguing whether their oil price target controlled the global oil market, or their output quotas controlled the global oil market. The output quotas allowed them to hit the price target. Two sides of the same coin.]

This is what I mean by a Rube Goldberg device. The logical way to do this would be to directly adjust the base in such a way as to stabilize the price of CPI or NGDP futures contracts, much as under a fixed exchange rate regime the monetary authority adjusts the monetary base in such a way as to stabilize the exchange rate.

Instead, they adjusted the interest rate target in a way that they believed (hoped?) would cause the monetary base to grow 2% faster than the real demand for base money. But due to the conflicting liquidity and Fisher effects, that’s hard to do. Interest rates are a clumsy tool.

And then in 2008 they made things even more complicated by adding interest on bank reserves. Even if IOR has microeconomic efficiency advantages (more liquidity), the Rube Goldberg device got even more complex. Instead of a clean split with the Fed controlling the supply of base money and the public determining the real demand for base money, the Fed could now influence the demand for base money as well, by adjusting the interest rate paid on bank reserves. That made money looks even less central to the process than was the case during 1982-2008.

Skeptic: You have not addressed the indeterminacy problem with using interest rates as an instrument of monetary policy. The fiscal theory of the price level gives us a way to pin down the price level.

Me: Yes, but it is not the only way. Even if John Taylor is wrong about the Taylor Rule, you can control inflation by adjusting the base to stabilize a price target other than interest rates, as with the gold standard and/or a fixed exchange rate regime.

Skeptic: But the gold standard is obsolete, and fixed exchange rate regimes tend to eventually collapse.

Me: But the price target need not be fixed. Singapore’s central bank targets exchange rates rather than interest rates and then adjusts its exchange rate target as needed to keep Singaporean inflation at the desired level. There’s no indeterminacy problem with using a price target rather than an interest rate target as the monetary policy instrument.

Skeptic: But the US is too big to use the exchange rate as the policy instrument, it would destabilize the world economy.

Me: I’m not sure that’s true, but in any case I favor using adjustments in the monetary base to stabilize the price of NGDP futures contracts, or CPI futures contracts if you insist on inflation targeting.

To summarize: Stop using discretionary fiscal policy. Stop targeting interest rates. Stop paying interest on bank reserves. Go back to the small pre-2008 Fed balance sheet. Simply adjust the base (likely to be 98% currency) as needed to keep NGDP futures prices growing along a 4% trend line. Like the gold standard, but with NGDP futures contracts replacing gold.

ChatGPT presents our current monetary regime, as seen by a market monetarist:

We need to make it much simpler.

Part 2: What is the empirical evidence?

Why can’t monetary policy disputes be resolved by looking at the empirical evidence? Partly because almost everything is up for debate. Both monetary and fiscal policy are hard to quantify, as people disagree as to the best policy indicators. What is easy money? What is an expansionary fiscal policy? And recent theoretical innovations emphasize the importance of changes in the expected future path of policy, which is even harder to estimate.

I’m not going to be able to resolve these problems in a blog post, but I’d like to respond to a few empirical observations made by John in his analysis of monetarism:

Most of the historical episodes adduced to support monetarist theories of inflation involve printing money to cover intractable deficits. These are just the sort of episodes where monetarism and fiscal theory agree. Inflationary episodes do not come from mistaken money supply control in healthy economies with sound public finances. Even Milton Friedman once said2 “What produces [inflation] is too much government spending and too much government creation of money and nothing else.” Fiscal theory and monetarism may disagree a bit on the magnitude of a helicopter drop’s effect. If government debt is much larger than the money stock, a given helicopter drop is a larger proportionate rise in the money stock than it is a rise in government debt, so monetarism predicts a quantitatively larger response. We can imagine a near-ideal experiment to tell fiscal theory and monetarism apart: First, create $3 trillion of reserves and exchange them for government bonds. See what happens to inflation. Then create $3 trillion of reserves and hand them out, essentially dropping money from helicopters, with no announcement of taxes or future spending restraint to soak up that money. See what happens to inflation. The theories make clear predictions: Monetarism says the two exercises will produce exactly the same inflation. Fiscal theory says only the second will produce inflation. Our governments just ran this experiment. In three rounds of quantitative easing the Fed brought reserves from under $50 billion in 2007 to $2,800 billion in 2014. The corresponding assets, mostly treasury and mortgage-backed securities, rose from $880 billion in 2007 to $4,500 billion at the end of 2014. Quantitative easing had no discernible effect on inflation. Then, in 2020-2021 the Fed increased reserves from $1,727 billion (February 2020) to $4180 billion (Dec 2021) and leveling off at $3281 billion (Aug 2025). Assets rose from $4,171 billion to a peak of $8,965 billion in 2022. But this time the Fed financed deficits, allowing the Treasury to send people checks of all this new money without having to convince investors to hold trillions of new treasury debt. This time, we saw substantial inflation. It would be hard to ask for a clearer test between monetarism and fiscal theory. The immense size puts quibbles to rest. Quantitative easing raised reserves by a factor of 50, i.e. by 5,000%. Quantitative easing should have been an atom bomb, a hyperinflation. Instead we are left arguing whether quantitative easing might have lowered long-term bond yields by 10 basis points or so and for how long.

I agree with John that there are some problems with traditional monetarism, but I believe even those problems are overstated. Traditional monetarists never favored using the monetary base as an indicator of policy, and the M2 money supply rose far more in 2021-22 than during and after the Great Recession. Today, monetarists often use Divisia indices, which do a reasonable job of accounting for the high post-Covid inflation:

Let’s not forget that monetarists like Bob Hetzel and Tim Congdon provided some of the most accurate warnings about the post-Covid inflation (and the 2008 recession). And as I remarked in the previous post, I was arguing that QE would not cause high inflation during the early 2010s, even as some FTPL proponents were worried about inflation. So, I don’t see how John can argue that these events were in any sense a definitive test of the relative merits of monetarism and the FTPL.

Consider this observation:

Most of the historical episodes adduced to support monetarist theories of inflation involve printing money to cover intractable deficits.

OK, then let’s consider a bunch of cases where monetary and fiscal policy seemed to move in opposite directions. Here are five examples, off the top of my head:

1. In the 1990s and 2000s, Japan does some of the most expansionary fiscal policy in all of world history, with lots of big infrastructure projects aimed at boosting demand, which led to a huge increase in the Japanese national debt as a share of GDP. To suggest the effects on spending were small would be an understatement, as GDP actually declined during 1994-2012, even in nominal terms. That’s an almost unprecedentedly weak growth in NGDP after a near all-time large fiscal stimulus.
2. In 2013, Prime Minister Abe reversed course, raising the BOJ’s inflation target while tightening up fiscal policy to reduce the deficit. There were several big tax increases. NGDP finally started growing, although inflation remained below target until recently. Money seemed to dominate fiscal.
3. In 1968, President Johnson raised taxes to slow inflation, creating a budget surplus in the 1968-69 fiscal year. Monetary policy remained expansionary, however, and inflation continued to accelerate. The Great Inflation began during the 1960s, a decade with very small budget deficits. John might argue that current deficits don’t matter; it is the long run expected path of fiscal deficits that is important. But I’d argue the same for the monetary base and IOR.
4. In the early 1980s, Paul Volcker adopted a contractionary monetary policy at a time when Reagan was cutting taxes and boosting military spending, resulting in a much larger budget deficit. Keynesians thought the large budget deficits would be inflationary, but they were wrong.
5. In 2013, Congress enacted fiscal austerity which reduced the budget deficit roughly in half, from about $1050 billion in (calendar) 2012 to roughly $550 billion. Keynesians said growth in spending would slow and that the 2013 austerity was a “test” of market monetarism. Nominal growth actually sped up.

Almost everywhere I look, I see evidence of monetary dominance. A monetary dog and a fiscal tail. That’s not to suggest that John is necessarily wrong about the post-Covid inflation. Any decent model, including my own market monetarist approach, puts a lot of weight on the importance of shifts in the future expected path of policy. It’s quite plausible that the big Covid fiscal stimulus contributed to public expecting that the Fed would allow more inflation than during the early 2010s. I cannot rule that out.

But note that another change occurred in 2020. The Fed committed to a “make-up policy”, something Ben Bernanke was not able to get his fellow FOMC members to accept when he proposed the idea back in 2003. What had changed is that academic work on level targeting by people like Michael Woodford was much more widely accepted in 2020, as in retrospect it was clear that the Fed did too little to boost recovery in the early 2010s.

It’s also possible that the strong recovery in 2021 had little to do with either monetary or fiscal policy and instead reflected the weird nature of the Covid recession, which was quite deep (peaking at 14% unemployment), but also artificially produced by a temporary shutdown, and that in retrospect a strong bounce back was to be expected. Macro data looked very abnormal during the Covid recession.

[Mea culpa: I did not anticipate the fast nominal recovery, nor did the financial markets. But fellow market monetarist Lars Christensen did.]

I want to be clear that I don’t view the five examples cited above as definitive. I recall that John has cited the Social Security reforms of 1983 as one reason inflation stayed muted despite the Reagan deficits. All of these events are complex. My point is that the comparison of the Great Recession and the Covid inflation doesn’t prove anything other than that the most naive form of monetarism—the view that the monetary base is a good indicator of the stance of monetary policy—is wrong. But more sophisticated versions of monetarism are still very much in play. Those include the Divisia approach, and (my preference) the focus on using adjustments in the monetary base to target NGDP futures prices.

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