ROI-Monetarist resurrection, or timely rethink of inflation targeting?: Mike Dolan

Be careful what you wish for. In reviving the Federal ​Reserve's long-dormant money-supply debate, Chair Kevin Warsh has created a headache for himself — and for the U.S. president who appointed him. Many ​of those most likely to cheer his monetarist turn are also most likely to want interest rates ‌higher, ​not lower. Some of the biggest critics of using inflation targeting alone to guide the Fed toward its mandate of stable prices think the wider financial picture and the current AI investment frenzy are reasons to consider whether policy is tight enough. Heading to the annual Jackson Hole symposium this week, Warsh has already set in motion a review of Fed functioning, with five task forces examining everything from communications and forecasting to inflation measurement, data ‌quality, productivity and the use of the balance sheet. Much of the discussion at the central banking jamboree in Wyoming is likely to be about the task forces, and some have billed these examinations as the most consequential review of U.S. monetary policy since the Fed adopted a formal 2% inflation target in 2012. While denying he was a "monetarist" per se, despite being a student of arch 20th-century monetarist Milton Friedman, Warsh last month nodded to his preference for returning money-supply aggregates to the Fed's dashboard as part of a "mosaic of information". Targeting the stock of money in the system was all the rage during the inflation ‌spikes of the 1970s and 1980s, but it was abandoned by former Fed Chair Alan Greenspan as far back as 1993 for being unreliable due to financial innovation and the inability to capture the velocity of money — effectively, how often each unit of money is turned over.

But in ‌rehabilitating the use of money aggregates such as M2, which measures the growth of cash in circulation, deposits and easy-access savings funds, Warsh has reopened the age-old controversy about their applicability and potential dangers. And a ding-dong debate between monetarists and supporters of famed British economist John Maynard Keynes, who insisted economic demand management was more effective than targeting supply issues alone — even when it comes to money. Only last month, former Fed governor and Donald Trump adviser Stephen Miran jointly penned a paper for Hudson Bay Capital with economists Nouriel Roubini and Peter Ireland, called "A Return to Monetarism?". It argued for the inclusion of money and credit, at minimum, in Fed deliberations — as Warsh now appears to advocate. One key argument is that the explosion of M2 ⁠money-supply growth during the ​pandemic reboot, amid government support, directly seeded the subsequent inflation spike and should ⁠have alerted the Fed to the dangers sooner. Those findings were dismissed this month as "soft monetarism" by Keynesian economist James Galbraith, son of Friedman-adversary John Kenneth Galbraith and a former congressional adviser during the money-targeting vogue of the early 1980s. Among the pushbacks, he argued that using money supply and the velocity of circulation remained fraught with problems.

"If the velocity of money isn’t ⁠stable—and it certainly wasn’t during the COVID-19 pandemic or on many other occasions—the “quantity theory” cannot be used to inform policy," he wrote. MONETARIST EASTER EGG What's more, supporters of tracking money-supply growth who think monetary policy may be too tight right now may find the latest M2 numbers comfortable reading. Annual M2 growth hit a four-year high of 5.14% last ​month — almost two percentage points faster than the Fed's favored inflation rate. The Fed's monetary policy report last month unusually referenced M2, which Warsh described as a hidden "Easter egg", and said 5% growth was closer to the norm of the low-inflation 2010s after wild swings during ⁠the past six years.

But the Fed's money-supply debate has gone global. Former European Central Bank chief economist and Bundesbanker Otmar Issing wrote in Central Banking magazine this week that the ECB's original "twin pillar" approach — incorporating economic and monetary analysis and cross-checking them before setting policy — made sense. Looking beyond simple inflation targets was now necessary. Issing acknowledged that "the heydays of monetarism belong to a distant past", ⁠but ​added that it was dangerous to ignore money supply and the risks from the banking system and financial markets, with all their dynamics, non-linearities and overall complexity. Issing also hat-tipped one of Warsh's new task force members, William White, a former chief economist at the Bank for International Settlements, a longtime critic of narrow inflation targeting and famed for warning in the early 2000s that U.S. monetary policy was far too loose to control the mounting credit bubble that led to the global banking crash of 2008. In an article called "Monetary policy's dead end" earlier this year, White argued that it was time ⁠to end narrow inflation targeting as central-bank orthodoxy because it skirts financial-sector excesses and their 'procyclicality', stokes debt accumulation and will ultimately force governments into financial repression and inflation to repay debt. And if White's views are any measure of shifting thinking within the Fed, he's adamant that interest rates should ⁠not come down in the current frothy financial and investment environment.

"Lowering rates today ⁠in the face of a similar shock (to the 2008 crash) might be even more dangerous," he wrote, pointing to the massive scale of AI spending that's "potentially inflationary" and has an unproven productivity payoff. Warsh may therefore need a sixth task force on how to reconcile his monetarist redux with Trump's interest rate wishes. (The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source ‌for global financial commentary. Follow ROI on LinkedIn, and X. And ‌listen to the Morning Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets ​and finance seven days a week.

(By Mike Dolan; Editing by Marguerita Choy)