An Open Letter to the Federal Reserve

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This is part of The Digital Money Book.

Inflation is always and everywhere a monetary phenomenon.
— Milton Friedman

This week, the Fed is meeting in Chicago to listen and learn some new ideas in monetary policy. In particular, they are looking for smart ways to hit their stated 2-percent inflation target. I submit a proposal by Scott Sumner and other market monetarists to help the Fed see a better way to manage the dollar. This short essay is the third in a series:

  1. A Short Primer on Money
  2. Cryptocurrencies are Not Money

A quick summary: cryptocurrencies and gold are not money; most central banks make bad decisions and hurt their own people by causing recessions. In this essay, I want to explain what monetary policy is and how we can fix it.

Monetary policy is how an independent branch of the government called the central bank manages interest rates and the money supply to promote and stabilize long-term economic growth. Monetary policy should be countercyclical, acting as a shock absorber against the business cycle. Too often, it is procyclical and makes a bad situation worse.

Monetary policy is often based on a dual mandate — keeping both inflation and unemployment under control. Most countries follow the US Fed, and the Fed is a very conservative and quasi-political organization. They use Keynesian (outdated) models to understand the world. They modify interest rates, bank reserve requirements, interest on reserves, and open-market operations (creating and destroying money) in an effort to control inflation and unemployment. It works some of the time, in much the same way a broken watch tells the correct time twice a day. But during extreme events, when there is a supply or demand shock, it usually backfires and causes a recession.

More and more economists are coming to realize that setting interest rates isn’t as effective as they had thought. Instead, the amount of money in circulation is the only determinant of long-term inflation. A common thought experiment is: If the amount of money in your country today doubled overnight, and everyone immediately knew that fact by 7am, almost all prices would double by noon. In real life, we see prices rising rapidly in response to hyperinflative money printing, though the process is more complex. If the central bank adds 2 percent more money to the money supply, prices don’t rise overnight, but they do eventually rise by 2 percent in the long term. When people have more money to spend, prices generally rise in response.

If the government takes money from the federal budget and just sends $100 to every citizen, that might stimulate the economy in the short run. That’s not creating money. That’s taking money already in circulation and spending it on one thing rather than another. If the government took that same money and built more housing or bridges, that would put people to work. They would spend the money, and it would also stimulate the economy in the short run. That’s called fiscal stimulus, and it is always quite limited in its effect.

However, if the treasury simply prints a bit more money (adds more new money to its own account simply by changing the number) and puts that new money into circulation, that creates a corresponding bit of inflation that can stimulate the economy for years.

The key is whether money is in circulation or out of circulation. To stimulate the economy, the central bank buys government debt or other financial assets. Now those assets are out of circulation (this is known as the central bank’s balance sheet) and the newly created money is now in circulation. When they want to cool off the economy, they sell their assets, pulling cash out of circulation.

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Because they can create as much money as they want, central banks have infinite economic resources. It’s very important that they use this power only to enforce a steady-growth regime and not to print money when the government wants to spend more or has a need for more money.

Central bankers only create and destroy base money, which is a fraction of total money in the economy. They must take into account the multiplier effect, which involves 1) banks lending money (despite YouTube videos to the contrary, banks do not create money out of thin air the way the central bank does), and 2) the velocity of money (how many times a dollar changes hands per year). Both factors determine the total amount of money in circulation.

Austrian economists say inflation is bad. They say it “erodes the spending power of your money.” Look, they say, a movie ticket used to cost $10, now it costs $20. They show images with shopping carts buying less and less food over the years.

This is what Irving Fisher called The Money Illusion — the tendency of people to think in terms of dollars in their wallet, rather than adjusting for inflation. Back when your movie ticket cost $10, what was your income? It was a lot less than it is today. In general, wages outpace inflation, so we continue to collect a paycheck that actually buys more and more goods over time!

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In fact, if inflation were to rise, our wages would also rise. What matters is the gap between them. In general, the amount of money the ticket seller at the theater earns will double faster than the price of the tickets.

The same is true with investments and real estate — they go up faster than inflation. So the only people hurt by inflation are those who keep a large amount of cash under the mattress or in a vault. Everyone else’s buying power continues to increase as wages and investments outpace inflation.

You can think of inflation like heating and air conditioning for our homes. Too little or too much heat can make us very uncomfortable, but the right amount makes us happy and productive. The same goes for air-conditioning. Your home needs a thermostat to keep the interior at a comfortable temperature. That way, you don’t have to keep deciding whether to add heat, reduce heat, add more cool air, or reduce the cool air. The thermostat does it automagically by itself, and that’s one less thing we need to think about.

Similarly, we don’t want to have too much inflation, but we also don’t want too little. We also don’t want too much economic growth, or too little. Somewhere around 2 percent inflation, there’s a “Goldilocks” amount that helps keep the economy growing steadily.

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Inflation: The 70s weren’t so good, 2010 was a disaster, but over the last ten years, inflation has trended under 2 percent.

There are different ways to measure inflation. The Fed uses a personal-consumption index, and there are a few different ways to measure it:

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Two of the measures show the Fed undershooting its 2 percent target. The green one is perhaps the best statistical measure, as it removes products with extreme price swings during the year.

Here are the reasons you want a small amount of consistent inflation:

  • It encourages people to spend now and gets money moving. Cash on hand is an important measure of a person or firm’s expectations of the future. If we don’t have enough cash on hand and the future is uncertain, we’ll delay purchasing, and that slows the velocity of money, which slows the economy.
  • It overcomes wage stickiness. Both wages and prices are sticky — they don’t adjust quickly to market realities. Nobody likes to take a cut in salary, and landlords don’t like to accept less rent. Banks don’t want to accept less than their monthly payment. Yet, when there’s a drop in demand, something has to give. A bit of inflation acts as a buffer — if there is a recession and prices don’t go up, they can understand that and wait for better times. It’s a lot better (psychologically) than having to swallow a pay cut.
  • Prices are sticky. No one wants to adjust prices every day. If inflation is high, prices will need to change often. People will constantly scout for slow price adjustments and arbitrage the price changes. There will be too much money-induced activity in the economy. At 2 percent inflation, the economy gets a boost and prices double every 36 years, which is generally acceptable.
  • A reliable amount of inflation benefits everyone. If inflation bounces between zero and six percent, banks don’t know how to lend, so they lend inefficiently to protect themselves. If the central bank hits two percent inflation each year, everyone can plan on it and lenders will lend more efficiently, passing those savings on to borrowers.
  • Too little inflation harms growth. A society at 1 percent inflation will grow more slowly than an economy with 2 percent. For most economies, 2 percent is the “Goldilocks amount” that stimulates growth without causing instability. The right number for a given economy may depend on population growth, technology adoption, and other factors.
  • Negative inflation is bad. The opposite of inflation is deflation. In a deflationary economy, people are more likely to hold onto money than spend it. This is a strong sign that there isn’t enough money in the economy. By the time you see deflation, it’s time to add quite a bit of money to the circulating supply, and fast.

If 2 percent inflation is your goal, how do you achieve it consistently? You want to build a thermostat for the economy, to keep inflation “just right.” Let’s learn a few more key terms …

Nominal GDP vs Real GDP: Sal Khan explains the difference between real GDP and nominal GDP in his excellent video tutorial …

People often talk about real GDP, which is a nation’s output adjusted for inflation. Nominal just means “unadjusted for inflation.” Nominal GDP is the actual dollars flowing through the economy. You have nominal dollars in your wallet and get paid in nominal dollars. You borrow nominal dollars and repay your loan in nominal dollars. So if we track the amount of output in actual dollars without adjusting for inflation, we have an accurate view of demand. That leads to …

Nominal GDP Targeting is a monetary policy that trades two variables and their uncertainties (inflation and unemployment) for a single variable: nominal GDP. Let’s suppose you want to target 2 percent inflation and 3 percent economic growth. Then you would want to have 5 percent more money circulating this year than last year. The cool trick of NGDP is that you don’t care whether …

  • Inflation is 1 percent and growth is 4 percent
  • Inflation is 2 percent and growth is 3 percent
  • Inflation is 2.5 percent and growth is 2.5 percent
  • Inflation is 3 percent and growth is 2 percent
  • Inflation is 4 percent and growth is 1 percent.

These are all equivalent under NGDP targeting. So to stabilize an economy, you aim for consistent 5 percent nominal growth, and you ignore the two components. If there is $10 trillion in circulation at the beginning of the year, you want $10.5 trillion in circulation at the end. No more, no less. In this scheme, the central bank only looks at nominal GDP, nothing else.

This is called Nominal GDP Level targeting because if the central bank sees that they are undershooting, they overcompensate, and if they see that they are overshooting, they undercompensate, so the NGPD prediction comes back into target range. They do not scratch their heads and “try harder” when they undershoot, they add even more money to the economy to compensate for previous shortfalls. This is not too different from the way the heating system has to heat your home if a window is open in winter. It sometimes has to overcompensate to stay on target.

One really really really cool thing about NGDP level targeting is that it doesn’t care what the mechanisms are or if they change. How does adding $x to base money change the amount of money in circulation? It doesn’t matter. It happens somehow. If you add some money into circulation and you don’t hit your projected target, just add more. This is analogous to heating your home whether the door is open or not — you don’t need to know if the door is open, you just need to keep adding heat until the thermostat gives the number you want. It’s really flying by instrument rather than by gut feel or by thinking you understand how the economy works. You don’t need to know how the economy works. You just need to keep adding or subtracting money to get to the actual goal you want to accomplish.

This is called focusing on terminal values, rather than instrumental values. Because the thermostat tells the actual temperature in your house, the terminal value is the thermostat number, while the instrumental values may have to do with how much heat is being applied. It’s the same with the economy — you may not know how it works or what intermediate goals to target, but you do know whether you are hitting your inflation target. The problem is, you don’t learn what inflation is until later. There’s no gauge that shows what inflation is right now.

The monetarist tool is the amount of money in circulation. If monetarists had their way, central banks would have nothing to do with bank regulations and interest rates. Instead, they would build a mechanism that automatically adjusts the amount of money in the economy to meet a pre-defined 5 percent nominal GDP target at the end of each year. This is called market monetarism. It works like this:

  1. The central bank declares a target of 5 percent nominal GDP growth by the end of the year. They pledge to use the power of their balance sheet to accomplish that. Since their balance sheet is infinite, this is a big deal.
  2. Central banks can’t see the future. They get economic data that is usually months old. How can they tell whether they are going to hit their target? How can they decide whether to stimulate (add money) or cool off (pull money out of circulation)? They can use a prediction market, where people buy and sell futures contracts based on whether NGDP will hit the stated target. The wisdom of the crowd betting their own money is about the best mechanism for predicting the future level of NGDP.
  3. They feed that information into an algorithm that automatically adjusts the amount of money in circulation. There are different ways to do this, but essentially if the market says they are undershooting, they create money and put it into circulation, and if the market says they are overshooting, they pull money back. They should do this at least weekly, but eventually daily would be better.

The important thing is that everyone knows the monetary policy is now on autopilot — like a thermostat — and that the central bank is willing to create or destroy as much money as it takes every day to hit the target exactly at the end of each year.

This becomes a self-fulfilling prophecy. Everyone knows the central bank has more money than anyone, so if the central bank keeps its word then nominal GDP will hit the target. Simply the threat does the job. With the money supply on autopilot, the central bank doesn’t need to do much, and fears of uncertainty, recession, and deflation disappear.

This automated approach hasn’t been tried, but it is more or less the way the Australian central bank works, and they haven’t had a serious recession since the early 1990s (though their growth is now slower than it should be). There are different ways to implement this thermostat approach. We will need research to refine and adjust the model as necessary — especially if the population changes or technology has an impact on stickiness. But more and more economists are starting to see that nominal GDP level targeting would be a huge improvement over today’s monetary policy.

Market monetarism is the subset of the monetarist school that includes step 2 above. They believe markets are better at setting prices than experts are, and that an automated monetary policy that uses NGDP futures data as input will provide the necessary countercyclical adjustments to maximize sustainable economic growth.

Nominal GDP level targeting should eliminate recessions and provide a strong counterbalance to shocks. It keeps GDP growing, which makes your take-home pay worth more (buy more stuff) in the long run. When inflation is lower than the 2-percent target, it means the economy is underperforming. Life would be better for everyone if central bankers would just print more money.

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Scott Sumner’s car — nominal GDP level targeting.

And that’s what we hope the Fed will listen to when they meet in Chicago this week. They know about NGDP level targeting, but they don’t take it seriously. It seems too risky to them. That’s why Scott Sumner and David Beckworth are there — to help the Fed look at this thermostat and consider how it could benefit the US economy.

Come to Cutting Through the Noise and sign up for my newsletter.

My thanks to Rob Siegel and Kevin Dick for their helpful reviews and suggestions.

Eliezer Yukowsky on how central bankers can learn to create more inflation and help their citizens (recommended).

Scott Sumner on The Case for Nominal GDP Level Targeting.

Nominal GDP Level Targeting for Dummies (easy and fun to read).

The Case for CBDC, Cato Institute (technical).

Scott Sumner’s blog, The Money Illusion.

David Beckworth’s podcast, Macro Musings.

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This is part of The Digital Money Book.

David Siegel is a serial entrepreneur in London. He is the founder of two blockchain companies — the Pillar Project and 2030. He is also the founder of Cutting Through the Noise and

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Provocateur, professional heretic, slayer of myths, speaker of truthiness to powerfulness, and defender of the Oxford comma.

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