Abstract

The Federal Reserve System (Fed) is a regular feature in the media. When the Fed communicates with the public, its focus is on forward guidance related to monetary policy—specifically, for achieving low unemployment and low inflation. Fed participants on the Federal Open Market Committee (FOMC) convey what they see as the likely path of policy, including changes in the federal funds rate, a standard monetary policy tool. Because financial markets find this information useful, news stories thoroughly cover Fed communication.

However, such communication fails to explain the structure of the economy that disciplines how the FOMC achieves its objectives for employment and inflation. The FOMC necessarily conducts monetary policy based on assumptions about this structure. What is now implicit should be made explicit. Such explicitness by the FOMC is necessary for the public to understand the monetary standard that it has created. That is, the Fed needs to explain the framework it assumes to then explain how its actions translate into achievement of its objectives.

Such transparency will be challenging. The standard Fed narrative implicitly assumes that a free-market economy and financial markets are inherently unstable. Economic instability originates in the private sector, and an independent Fed is required to mitigate this instability. Again, implicitly, the assumption is that the Fed understands the structure of the economy so that it knows the origin of instability and how its actions will offset that instability.

Despite the Fed narrative, there is a need for a debate over the optimal monetary standard. In the 1960s, the monetarist-Keynesian debate raised the key issues relevant to the design of the optimal monetary standard. Is inflation a monetary or a nonmonetary phenomenon? What accounts for the simultaneous occurrence of monetary instability and real instability. Does the direction of causation go from monetary to real instability or vice versa? The intent of this article is to revive the earlier debate. To do so, it will be necessary to re-exposit monetarism in a way relevant to current central bank practice. To do so, I re-exposit monetarism in a way that is relevant to current central bank practice, using the term "Wicksellian monetarism" as the descriptive label.

Such a debate is especially urgent at present given the FOMC's current policy of disinflation. The FOMC needs to articulate a monetary policy in terms of a long-term strategy (rule) that will restore price stability and then maintain that stability. How does current policy ensure that a declining rate of inflation will stop at 2 percent and then remain there? That is, for the long run, the policy needs to provide a stable nominal anchor. Such a policy should allow the FOMC to lower the federal funds rate to prevent a serious recession while maintaining credibility for a long-run policy to restore price stability.

Robert Hetzel is a retired economist from the Federal Reserve Bank of Richmond. He has written three books on the history of the Federal Reserve System: The Monetary Policy of the Federal Reserve: A History (2008) and The Great Recession: Market Failure or Policy Failure? (2012), both published by Cambridge University Press, and The Federal Reserve-A New History (2022), published by the University of Chicago Press. He is a senior affiliated scholar at the Mercatus Center at George Mason University; fellow in the Institute for Applied Economics at Johns Hopkins University; and visiting scholar at the Federal Reserve Bank of Chicago.

The ideas in this article draw on the monetarist tradition developed by a remarkable assemblage of economists at the Federal Reserve Bank of St. Louis in the 1960s and 1970s, attracted by Homer Jones, the research director at the time: Leonall Andersen, Richard Anderson, Anatol (Ted) Balbach, Al Burger, Rik Hafer, Scott Hein, Jerry Jordan, Michael Keran, Jim Meigs, Robert Rasche, and Jack Tatom. The St. Louis Fed also publicized work by Karl Brunner, Allan Meltzer, and Anna Schwartz. See Bordo and Schwartz (2008). This article is dedicated to Marvin Goodfriend, from whom the author drew inspiration. An earlier iteration of this article appeared in the working paper series of the Mercatus Center at George Mason University.

INTRODUCTION

The monetary standard is the framework within which the FOMC pursues its objectives. That framework clarifies not only the objectives of monetary policy but also the structure of the economy that intermediates the monetary policy actions of the FOMC and the behavior of its objectives. Given those objectives, monetary policy is the reaction function (the rule) the FOMC uses to set its instrument (the federal funds rate) in response to incoming information on the economy. Although the FOMC lacks a detailed model of the structure of the economy, it still must choose a monetary policy based on assumptions about the basic character of that structure. 

The design of the optimal monetary standard and of a stabilizing monetary policy depends upon the character of inflation. If inflation is a monetary phenomenon, monetary policy must provide for monetary control. The control of paper money creation through the bookkeeping open-market operations of the New York Fed's Open Market Trading Desk does not provide the FOMC with the ability to control systematically the behavior of the real economy. Monetary policy must give free rein to the stabilizing properties of the price system to control real variables (output and employment).

Alternatively, if inflation is a nonmonetary phenomenon, to control inflation, monetary policy must control slack in the utilization of resources. The control of slack necessitates balancing the objectives of unemployment, which increases with slack, and inflation, which decreases with slack. The trade-offs are given by the empirical relationship known as the Phillips curve. In the former case in which inflation is a monetary phenomenon, the FOMC is relying on the stabilizing properties of the price system to achieve full employment. In the latter case in which inflation is a nonmonetary phenomenon, it is overriding those properties by manipulating slack in the economy. 

There is a lack of professional consensus over the nature of inflation and the strength of the stabilizing properties of the price system. That reality in no way obviates the need for the Fed to choose a monetary policy based on an assumption about these characteristics of the economy. Heuristically, the FOMC must decide whether to juggle one ball or two balls. That is, should it concentrate on one ball (price stability) and leave unaided market forces to deal with the other ball (unemployment)? Alternatively, should it juggle two balls by manipulating inflation-unemployment trade-offs? Transparency about the monetary standard that the FOMC has created would require it to clarify its assumptions and subject them to professional debate. The two views that have historically defined the debate are "traditional Keynesian" and "Wicksellian monetarism."

Throughout the 1970s, a vigorous monetarist-Keynesian debate contested the issues basic to the design of the optimal monetary standard. Given the long period of relative quiescence in inflation after the Volcker disinflation, the debate receded. Given the current rise in inflation, the debate should be revived. However, given the fact that the FOMC ignores the behavior of money and uses an interest rate rather than a reserves aggregate as its instrument, the original monetarist views appear to have lost relevance. This paper re-exposits monetarism as Wicksellian monetarism to make it relevant to current practice. To reinforce the point that there remains a need to revive the earlier debate to confront the basic issues that must be decided in the design of the optimal monetary standard, this article contrasts the two views—traditional Keynesianism and Wicksellian monetarism.

Policy in the Keynesian tradition implicitly assumes that inflation is a nonmonetary phenomenon. A stickiness in relative prices that imparts inertia to market clearing prices causes the price system to work only poorly to maintain full employment. FOMC procedures for setting the federal funds rate must override the operation of the price system to manage purposefully slack in the economy. Necessarily, the FOMC balances off the two competing targets of low unemployment and low inflation using the trade-off given by the empirical relationship known as the Phillips curve.

Policy in the Wicksellian monetarist tradition implicitly assumes that inflation is a monetary phenomenon. Given a rule based on maintenance of the expectation of price stability—that is, a stable nominal anchor—the stabilizing properties of the price system work well to maintain full employment. FOMC procedures that cause the federal funds rate target to track the natural rate of interest turn over to the unfettered operation of the price system the determination of real variables (output and employment).

Read the full article.