Poole on Friedman’s Monetary Legacy

Like Andrew Coulson, I attended an event in honor of Milton Friedman’s birthday yesterday. This one was in Missouri, and it featured Bill Poole, who’s president of the Saint Louis Federal Reserve Bank and a frequent participant in Cato events on monetary policy. The event was sponsored by the University of Missouri and the Show-Me Institute. In his speech, he credited Friedman with making the case that changes in the money supply are a major factor in the business cycle. However, he noted that modern-day central bankers do not agree with Friedman’s contention that central banks should focus on limiting the growth of the money supply:

Everything Milton argued about money stock control is true, but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis. The economy functions differently when inflation expectations are firmly anchored. If a central bank allows expectations to become unanchored, then interest-rate control becomes a dangerous and potentially destabilizing policy. But should the practice of monetary policy depend on how well inflation expectations are anchored? I do not recall Milton discussing this question, perhaps because he believed that the best way to maintain well-anchored expectations over time was for the central bank to commit to steady and low money growth under all circumstances.

How does a central bank anchor inflation expectations? One approach would be for the central bank to commit to low and steady money growth come what may. A problem with this approach is that it may not appear credible to the markets when financial instability and/or recession occurs. If a policy of steady money growth has exceptions, can the exceptions be defined in such a way to retain anchored inflation expectations?

A necessary and sufficient condition for anchoring is that the central bank act vigorously to resist inflation or deflation whenever it becomes evident and particularly when inflation expectations change, up or down, in an unwelcome way. If the central bank is willing to push as hard as it takes, regardless of short-run consequences to unemployment and especially to the bond and stock markets, then market participants will develop firm views on the likely rate of inflation in the future. The Fed must convince market participants who bet against it that they will regret their bets.

However, Poole concludes that “Although Milton did not prevail in his quest to have the Fed maintain a constant money-growth rate, he did prevail in his insistence that policy be apolitical and rely to the maximum possible extent on market judgments. He lost a battle but truly did win the war.”