As Debate Rages, Simple Analogy Shows How Fed Controls Inflation

Nobel Laureate Economist Milton Friedman once famously said, "Inflation is always and everywhere a monetary phenomenon."

What causes inflation? Most people believe inflation is caused by central banks adjusting monetary conditions, as echoed in the famous Friedman quote above. But is this right? A recent study by some top economists has raised questions about this conventional wisdom.

The study found that the standard indicators central banks look to as measures of monetary conditions — economic slack, inflation expectations, and money growth — were, in fact, unrelated to inflation. These findings caused quite a stir and even led the Wall Street Journal to declare that “everything markets think they know about inflation might be wrong”.

So have economists been wrong all this time? Is inflation really determined by something other than central banks? The short answer is no. Central banks still determine the trend path of inflation.

In the United States, the Fed has successfully stabilized trend inflation around 2 percent a year since the early 1990s, as acknowledged by the authors of the study. Ironically, it is this very success that has led to the breakdown in the relationship between monetary conditions and inflation.  

To illustrate why, imagine that the Fed is a driver, the economy is a car, the gas pedal is monetary policy and the car's speed is the inflation rate. The Fed’s objective here is to keep the car moving steadily along at 65 miles per hour.

When the car starts climbing hills, the Fed pushes further down on the gas pedal. When the car starts descending from the hills, the Fed lays off the gas pedal. Over many hills and miles, the Fed is able to maintain 65 MPH by making these adjustments to the gas pedal.

A child sitting in the backseat of the car who was oblivious to the hills but saw the many changes to the gas pedal would probably conclude the gas pedal has no bearing on the speed of the car. After all, no matter what happened to the gas pedal the car’s speed never changed.

As outside observers, we know better. We know the driver was adjusting the gas pedal just enough to offset the ups and downs of the hills so that a constant speed was maintained. In terms of our Fed analogy, monetary policy was adjusted just enough to offset the ups and downs of the economy so that a stable inflation rate was maintained.

This is why so many observers get confused about monetary policy. Like the kid in the backseat, they saw the aggressive actions taken by central banks over the past eight years while also observing inflation remaining stable. Others saw the large amount of economic slack that emerged after 2008 while similarly witnessing inflation remaining stable. Both groups were perplexed and left wondering what was really driving inflation.  

These puzzles, however, are easily resolved once we realize that Fed and other central banks were like the driver of the car devoted to maintaining a constant speed. They used unconventional monetary policy, like large-scale asset purchases (LSAPs) and low interest rates, to offset the drag of economic weakness so that low, stable inflation was maintained.

Though these programs seemed large and radical, they actually were muzzled to avoid high inflation. The LSAPs, for example, were designed to be temporary and got sterilized by interest payments on excess reserves.  

Put differently, the unconventional monetary policy of the past eight years can be seen as central banks pushing down a little harder on their gas pedals to offset an especially steep hill — the Great Recession. 

Their desire to maintain a constant speed for inflation, however, also meant central banks were reluctant to run the economy hot and quickly eliminate the excess capacity in the economy. This is why inflation seems unrelated to monetary actions and economic slack since 2008.

Contrary, then, to buzz this new study has created, it actually underscores the influence central banks have on the trend path of inflation. As the authors themselves state, the lack of a relationship between standard monetary indicators and inflation is a “side effect of monetary policy success”.

To be clear, this conclusion does not imply commodity shocks and other supply disturbances have no effect on inflation. Rather, it means their effect on inflation is only temporary. Only monetary policy can shape the trend path of inflation. It is important, then, that we get monetary policy right.