Thursday, January 20, 2011

The Monetary Debate

Beckworth's primary discussion point of late has been trying to convince people that there was and is an excess of money demand: people and banks want to hold more money than is out there. That slows down monetary velocity, resulting in a recession. That basic story is told in a prison context and in multiple graphs.
If money demand has spiked, as these figures indicate, to an all time high then inflation fears are seriously misguided.  In fact, it doesn't matter how much the monetary base or money supply increases if money demand increases more. There simply will not be inflation.
Sumner, of course, agrees heartily. His main talking point, though, has been on when the medicine needed to be applied. There was already evidence he and Beckworth have shown that there were signs of excess money demand in June-Sep of 2008 before the financial institutions collapsed and before the stock market tanked. Had the Fed acted then and provided additional liquidity, the crisis need never have happened. Indeed, at the time it appears that folks were looking for any sign of monetary easing from any quarter. Once the crash took over, Cowen and others have argued, the Fed may have been powerless to step forward and credibly say they would NOW provide the needed liquidity. Sumner's response is that he is trying to prepare us for the next time we get to the zero interest rate bound. If people expect easing then, we can avoid the next crash altogether.

The real news last week in that with the release of the minutes from the 2005 Federal Reserve meeting, it is clear that the Fed knew a good deal in December about the housing bubble but did not change policy. The transcripts also show that Fed President Hoenig (of Kansas) has consistently claimed that high inflation was just around the corner, though he has never been right. Sumner points out that the Fed understood half of the story, admitting that there are exceptions when the Fed might actually want inflation above 2%, but not the full implications. Paraphrasing Cathy Minehan's statements in Feb 2005, he says:
if unemployment is sort of high, say 7%, and inflation was 3% due to energy price increases, you would not try to immediately bring inflation down to 2% if it meant pushing unemployment up to 9%.  And I am pretty sure that everyone at the Fed agrees with that.  However the inescapable implication of the argument is that if you have 9% unemployment and 2% inflation, you’d be better off pushing inflation up to 3% if it would reduce unemployment down to 7%.  The argument is completely symmetrical.

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