The Hoover Institution sponsored a conference this week at Stanford University to commemorate the 50-year anniversary of the Shadow Open Committee (SOMC). It was founded by monetarist economists Allen Meltzer, Karl Brunner and Anna Schwartz in the early 1970s when inflation spiked to a post-WWII high.
The opening paper by Michael Bordo and Mickey Levy documents the SOMC’s history and the evolution of U.S. monetary policy over the past five decades.[1] It highlights key differences in policy prescriptions between Fed officials and SOMC members throughout this period. It also provides insights about the factors that influenced recent Fed policymakers’ decisions that resulted in them being slow to react to the surge in inflation in 2021-2022.
When inflation surfaced in the early 1970s, SOMC members championed the argument by Milton Friedman that inflation is a monetary phenomenon and reducing the growth rate of the monetary stock is necessary to lower inflation. However, this prescription was ignored by Arthur Burns, and inflation reached double digit levels by the end of the decade. Paul Volcker subsequently switched policy from targeting interest rates to target the growth of non-borrowed reserves, which proved successful in lowering inflation and inflation expectations following a severe recession in 1981-1982.
Monetarism then fell out of favor with the Fed during the Great Moderation of the 1980s and 1990s. One reason was the velocity of money, which monetarists presumed would be stable, rose markedly during the inflation in 1977-1980, and it fell sharply during the 1981-1982 recession. In addition, the money multipliers (monetary aggregates divided by the monetary base) also fluctuated due to financial market liberalization and a proliferation of financial innovations. As a result, the growth of money became less reliable in predicting the economy, and the Fed reverted to targeting interest rates while it de-emphasized the money supply.
The Fed became fearful of deflation in the early 2000s following the burst of the tech bubble and a 50% collapse of the stock market. Both Alan Greenspan and Ben Bernanke expressed concern about Japanese-style deflation. Bernanke also provided a blueprint of the Fed’s ability to ease monetary policy when it was faced with the zero lower bound during the 2008 Financial Crisis. Bordo and Levy observe that these concerns led the Fed to adopt an asymmetric interpretation of its dual mandate, tilting its priorities away from low inflation and toward higher inflation. By comparison, SOMC members argued strenuously against the Fed’s concern that the U.S. would fall into deflation.
The Fed’s concerns continued into the ensuing decade during Janet Yellen’s tenure as Fed chair. The Fed had anticipated a strong economic recovery considering it had lowered interest rates to zero and embarked on quantitative easing. However, the economy and labor market improved gradually. As a result, Yellen prioritized job growth while adding a new “Labor Market Dashboard” to its list of indicators to monitor.
The Fed undertook its first-ever strategic review in 2019 that culminated in a strategic plan that established an asymmetric interpretation of its dual mandate. It favored average inflation above 2%, prioritized maximum inclusive employment and formally deemphasized preemptive monetary tightening in response to anticipated higher inflation. When inflation spiked in 2021, the Fed viewed it as being caused by supply chain shortages that would be temporary. By comparison, SOMC members were among the earliest to predict the soaring inflation that ensued.
So, why was the Fed slow to react?
The Fed made several mistakes according to Bordo and Levy. However, the most important is that it was predisposed to believe inflation would stay low even as massive stimulus was injected into the economy that contributed to a V-shaped rebound from the Covid-19 pandemic.
In the process, the Fed became fixated on achieving maximum employment. It also completely ignored money supply growth (M2) that reached a peak of 27% in February of 2021. This pace far exceeded the rates of growth during either the quantitative easing programs of 2008-15 or the inflations of the 1970s and 1980s, according to the Federal Reserve Bank of St. Louis (see chart below.)
My view is that the Fed also misdiagnosed how the Covid-19 pandemic would play out. It responded the same way to the pandemic as the GFC even though they were very different types of shocks. The injection of bank reserve during the GFC did not translate into rapid money supply growth, because banks opted to hold excess reserves rather than extend loans to borrowers. This did not happen during the pandemic, because the financial system was unaffected by it.
So, what are the implications for monetary policy today?
The Fed’s decision to ease monetary policy by 50 basis points at the September FOMC meeting reflected its growing confidence that inflation was on course to reach its 2% target, while there were signs that the labor market was softening. However, the ensuing jobs report for September was much stronger than expected, which has caused some observers to question whether the Fed should pause now.
My take is the case for Fed easing policy rests on two arguments. First, as inflation has come down, real interest rates today are relatively high at about 2.5%- 3.0%. Second, money supply growth has decelerated steadily since the Fed began tightening monetary policy and it has recently turned negative (see chart). Accordingly, monetary policy is restrictive whether one looks at real interest rates or money supply growth. Therefore, it is appropriate for the Fed to adopt a neutral policy stance.
At the same time, Fed policymakers should acknowledge that the current economic cycle is different from previous ones in the post-war era. Consequently, I believe the Fed should lower interest rates in 25 basis-point increments rather than at a faster pace.
[1] The 50-Year History of the SOMC and the Evolution of Monetary Policy.