Warsh's Challenges: Monetary Policy
This is an OpEd at the Washington Post, their title “How to protect the economy from the ghosts of 1979.”
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When Kevin Warsh was nominated in January to be Federal Reserve chair, the monetary policy debate was over how quickly to lower interest rates. The Fed forecast that inflation would return to the central bank’s 2 percent target, already suggesting that interest rates should ease. The debate was over faster cuts. Artificial intelligence, the story goes, will swiftly raise productivity, making everything cheaper. Therefore, the Fed should quickly lower interest rates to steady prices and let wages rise.
Now, one could debate how soon and how reliably AI will create such bounty. One could also debate whether deflation (falling prices) with steady wages induced by AI-led productivity is a problem at all.Everything would become a lot more “affordable,” of course. There’s also an argument that higher real (after adjusting for inflation) interest rates are needed to induce savings and investment to build AI. Whether the Fed should act in anticipation of a productivity bonanza is another question.
But today the Fed faces essentially the opposite problem, a stagflationary shock that looks eerily like 1979. Inflation never really went away. It is now surging, thanks to tariffs and energy costs via a conflict with Iran. Should the central bank fight that inflation by raising rates, swiftly incurring President Donald Trump’s wrath and risking a weaker economy? Or should the Fed once again look through a price-level rise, hoping that the economy will stabilize at higher prices, and swiftly incurring the wrath of regular people already unhappy about today’s high prices?
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(Read the rest at Washington Post, this link should take you past the paywall. Full version here in a month.)
One hopes Cochrane is aware that Warsh is economically and mathematically ignorant. Evidenced by the Hoover transcript of Warsh's comments at the Hoover conference celebrating John Taylor: "The inflation rate, that is, the second- and third-order consequence of changes in prices, not the first-order change in the price level, is up to the world’s central banks." Anyone who passed high school knows that the inflation rate is precisely \Delta price/\Delta time, a pure first order effect. The second order effect is of course the acceleration/deceleration of inflation. Yes, if I had a perturbation theory model for the price level there would in principle be successive terms of increasing order, but only the first term is the inflation rate. To any competent scientist the idea that "the first-order change in the price level, is up to the world’s central banks." is ludicrous. The first order change is precisely what at any point in time the amount of money buyers exchange with sellers for real goods or services. If for instance the government credits people with new money in their accounts when the supply of goods and services is restricted then prices rise, regardless of what the central bank does because people don't have to borrow in the markets to cover the gap between their income and spending. Of course people could choose not to spend even with the government credit in their accounts and prices would fall. The economy of a developed country is ca. >80% wants not needs making changes in human wants the dominant factor economically. Some people drink water from the faucet, some drink $12 coffee drinks. Water is a human need, coffee is a human want. If somehow everyone decided to live like the historical Jesus the price level would collapse no matter what the central bank did with rates. Monetary policy could only work close to an economic control variable if all financing occurred via. bank loans from member banks (and even then it is not simple, take the limiting cases of a single private bank vs. millions of banks and work through the coupled equations). But that is not the world we live in, with global financial capital markets and plethora of financing vehicles. Rough estimates I have seen indicate daily currency transactions around the developed world are of the order of $10^13, the same order as the US yearly GDP. The financial world is massively interconnected and therefore very complex. Anyone, like Warsh, who claims the price level is simple and controlled by central banks (which banks?) is divorced from reality.
In half an hour, I'm discussing in Jeff Frieden's lunch group,
Annual Review of Political Science
The Politics of Inflation
Lucy Barnes
Department of Political Science, University College, London, United Kingdom;
I had two thoughts:
1. It would be great if everybody ran their articles through AI asking it to tighten them up, reduce verbosity,
2. How would inflation work in an economy with no cash or checking accounts, just credit cards for everything as the means of payment?
Number 2 is important for revising old-style monetary economics, even tho it isn't literally true.