Fed Theory Has Gone Against Monetarism
27 June 2017 | Pago Pago, American Samoa
The monetarist theory that justified narrowing central banks’ responsibilities to inflation targeting had very little empirical backing when Friedman proposed it. Since then, it has been refuted both by political experience and statistical testing. Monetary policy, far from being dissipated in rising prices, as the theory predicted, turned out to have a much greater impact on unemployment than on inflation, especially in the past 20 years.
Yellen finally came around, and shocked the world, when she said in September of 2015 that the Fed was entirely unconcerned about the risks of higher inflation and was eager to push unemployment below what most economists regard as its “natural” rate of around 5%.
It is this relationship – between inflation and unemployment – that lies at the heart of all controversies about monetary policy and central banking.
Friedman’s monetarist theory asserted that inflation would automatically and quickly accelerate without limit once unemployment fell below a minimum safe level, which he described as the “natural” unemployment rate. A few years later, Friedman’s “natural” rate was replaced with the less value-laden and more erudite-sounding “non-accelerating inflation rate of unemployment” (NAIRU). But the basic idea was always the same. If monetary policy is used to try to push unemployment below some pre-determined level, inflation will accelerate without limit and destroy jobs, according to the monetarists
The empirical refutation finally won. While the ideological attractiveness of monetarism, supported by the supposed authority of “rational” expectations, held sway for a good while, the modern research finally came to prevail a few years ago and is now Fed policy as indicated by current unemployment figures.
Monetary policy, far from being dissipated in rising prices, as Friedman and monetarism predicted, turned out to have a much greater impact on unemployment than on inflation, especially in the past 20 years.