Germany 1920s: worthless banknotes used as wallpaper

Monetarism and its discontents

Most mainstream economists still imagine that high interest rates are the most effective way to fight inflation. Michael Roberts begs to differ. Inflation is less a demand, more a supply issue

Once again the US Federal Reserve is in a quandary. Does it cut its policy interest rate soon, in order to relieve pressure on debt servicing costs for consumers and businesses, and perhaps avoid a ‘stagflationary’ economy (ie, low or no growth, alongside higher inflation)? Or does it hold its current interest rate for borrowing, in order to make sure inflation falls towards its target of 2% a year?

That is what mainstream economists and investors in financial assets want an answer to. But it is not really the important issue. What the Fed’s current quandary really shows is that yet again ‘monetary policy’ (ie, central banks adjusting interest rates and money supply) has little effect on controlling inflation in the prices of goods and services that households and businesses must pay.

Central bankers and mainstream economists continue to argue that monetary policy does make a difference to inflation rates. But the evidence is to the contrary. Monetary policy supposedly manages ‘aggregate demand’ in an economy by making it more or less expensive to borrow to spend (whether as consumption or investment).

However, the experience of the recent inflationary spike since the end of the pandemic slump in 2020 is clear. Inflation went up because of weakened and blocked supply chains, and the slow recovery in manufacturing production, not because of ‘excessive demand’, caused by either a government spending binge or ‘excessive’ wage rises (or both). And inflation started to subside as soon as the energy and food shortages and prices ebbed, global supply chain blockages were reduced and production began to pick up.

I will not go over the past evidence that inflation was supply-driven, not demand-led, which is overwhelming.1 But this meant that central bank monetary policy could take little credit for reducing inflation rates.2 And here is the rub: they are beginning to creep back up again - particularly in the US, where core inflation (which actually excludes food and energy prices) is now rising at over 4% a year on a three-month rolling average.

The reasons for this are twofold. First, food and energy prices have started to rise again. Oil prices have picked up, as the Houthis attack shipping in the Red Sea and Israel extends the war in Gaza towards Iran. And a key raw material for industry - copper - is in short supply and now has a record price.


The Fed is in a quandary and mainstream economists have been forced again to reconsider the efficacy of monetarism - the theory that inflation is caused by excessive money supply growth over output. Central banks have been squeezing money supply growth, supposedly to reduce inflation. But mainstream voices are showing uncertainty.

On May 1 the Financial Times published an article headed ‘The limits of what high interest rates can now achieve’, in which it commented: “We need to be realistic about what monetary policy can and cannot do.”3 The article admits that

the effectiveness of monetary policy also depends on the structural economic drivers around it. After all, the era of benign inflation before the financial crisis was bolstered by elastic production and energy supplies. Looking ahead, using rates with unreliable lags to influence demand is a recipe for volatility, as supply shocks from regionalisation, geopolitics and less supportive demographics continue - unless there are offsetting productivity gains.

The article concludes that “Fiscal and supply-side policy must get greater emphasis in the price stability debate. After all, a faulty faucet is even more useless if the plumbing has gone awry.”

Nevertheless, the article continued to claim that the monetary policy of the Fed and other central banks had helped to get inflation down. It cited various papers for this claim from the Bank for International Settlements and the Bank of England. But, when you go to those sources, the evidence again is to the contrary. Take the Bank of England paper quoted: it concludes:

UK inflation in 2021 is explained by shortages and energy price shocks, and in 2022 and 2023 also by food price shocks and labour market tightness. Inflation expectations have been more well-anchored than predicted by the model. Conditional projections suggest UK inflation will fall sharply in 2023 from disinflationary energy and food price effects, but the decline will slow markedly thereafter.4

Not much to do with ‘excessive demand’ then.

Even the ‘home of monetarism’, the Bank for International Settlements, is less than convincing in claiming that inflation was due to excessive money supply or even excessive demand. The BIS paper focuses its attention not on the initial causes of the inflationary spike, but on the likelihood that inflation will be “sticky” and not come down much because of the risk of workers taking advantage of “tight” labour markets to boost wages.5 The BIS is more worried about the hit to the profitability of companies than the fact that workers’ wages are still trying to catch up with a more than 20% rise in average prices since the end of the pandemic: “… in tighter markets, there is a greater likelihood that bargaining power will shift in favour of workers and the ‘pass-through’ between wages and prices will gain strength.” Oh dear. But even the BIS admits that “adverse demographic trends and pandemic-related preference shifts on the supply side can go a long way in explaining these dynamics”.

The final mainstream argument concerns inflation expectations. You see, households and even companies expect inflation to accelerate, so households buy more and companies hike prices more, achieving even higher inflation. But the ‘expectations theory’ is no theory at all. It can only operate if inflation is already rising and so cannot explain the initial spike, which is why expectations theory has been debunked as an explanation for rising inflation.6 And now, with falling inflation, the evidence for this ‘theory’ remains weak.

Allianz Research has disaggregated the nine-percentage point drop in America’s quarterly annualised inflation since the second quarter of 2022, using regression analysis. It found 5.5 percentage points of the drop was driven by supply-chain snags simply unwinding - around 60% of the decline. But AR reckons that 2.7 percentage points of the 9% fall was “due to the Federal Reserve’s signalling, which helped to re-anchor inflation expectations”. I leave you to work out what you make of the idea of “signalling”. Another 2.2 percentage points came from the impact of higher rates squeezing demand, which was needed to counteract the inflationary impact of supportive fiscal policy and labour shortages. Even if you accept this analysis, it means that 60%-80% of the decline in US inflation since the middle of 2022 was due to supply-side factors.

And that brings us to the ‘stickiness’ of inflation. Which components of the inflation index have not fallen despite central bank rate hikes? The answer is housing costs and motor car insurance, which have risen sharply. As the FT article admits,

Both are partly a product of pandemic supply shocks - reduced construction and a shortage of vehicle parts - that are still percolating through the supply chain. Indeed, dearer car insurance now is a product of past cost pressures in vehicles. Demand is not the central problem; there is little high rates can do.

The FT article concludes:

Either way, monetary policy is a catchall tool. It cannot control demand in a quick, linear or targeted manner. Other measures need to pick up the slack. Estimates suggest supply factors - which rates have little influence over - are now contributing more to US core inflation than demand.

Well, actually throughout this inflation rise and fall, it has been supply that has been the main driver.


Where to now? The risk is that the US economy could slow down towards stagnation in output, while inflation stays “sticky” because of a new rise in commodity prices. The US economy ended last year growing in real terms (ie, after accounting for inflation) at an annual rate of 3.4%. This was greeted with euphoria by the mainstream and the financial media: “The US economy is performing very well … We’re truly the envy of the world,” said one ‘econforecaster’, James Smith. But then in the first quarter of 2024, that annual rate in gross domestic product growth slowed to 1.6% - the slowest since the first half of 2022.

Moreover, the latest economic activity surveys (‘PMIs’) for the US make dismal reading. Any level below 50 indicates a contraction, but in April the PMIs for both the US manufacturing and services sectors were below 50 for the first time together.

Also, the jobs market is beginning to look frailer. Sure, the official US unemployment rate is still below 4%, but job hiring by US companies is dropping off, particularly among small firms, as the National Federation of Independent Businesses survey of hiring intentions shows - which seems a good forward indicator of jobs growth.

Indeed employees are now more reluctant to try to switch jobs, in case they do not get another - indeed, over the past two years, most new jobs have been part time, while full-time employment (that always pays better and with better conditions) has stagnated.

High interest rates, as set by the Fed and other central banks, are not controlling inflation. Instead, they are raising debt servicing costs for particularly small companies, just as corporate revenue growth also slows.7 Profitability is thus being squeezed - except for the mega ‘Magnificent Seven’ companies.

The ‘excess savings’ that households built up during the pandemic lockdowns appear to have been exhausted, while confidence to spend among American households has fallen to its lowest level in almost two years, as Americans become more pessimistic about future economic conditions.

In November 2023 former New York Fed chief William Dudley commented: “Does the unemployment rate have to rise to 4.25%-4.5% for the Fed to achieve their ‘final mile’ on getting inflation back down to two percent? If you think it does, then a hard landing is highly likely.” Claudia Sahm, another former Fed economist, reckons that if the unemployment rate runs some 0.5 percentage points above the bottom for three months, it is a very strong indicator of a recession in output.8 Currently, this Sahm indicator is now 0.36 percentage points above the lowest such reading for the previous 12 months. So not yet at the ‘recession’ threshold, but closing in.

Much of the recent growth in the US economy has been achieved by large increases in immigration.9 But, from here, the US economy will only avoid stagnation if productivity growth picks up. Moreover, what will keep inflation down would be a rise in output per worker per hour: ie, an increase in new value. Up to now, US productivity growth in the 2020s has remained relatively moderate.

The hope is that AI will bring about a ‘productivity revolution’ - setting the US economy on the road to a roaring 2020s, where real GDP grows faster than the long-term average, while inflation stays low.

At the moment, the opposite looks more likely.

Michael Roberts blogs at thenextrecession.wordpress.com

  1. See my article at thenextrecession.wordpress.com/2023/04/27/inflation-causes-and-solution.↩︎

  2. thenextrecession.wordpress.com/2022/10/28/the-inflation-conundrum.↩︎

  3. www.ft.com/content/a1866907-6b83-4493-91ca-91b04c60d1b7.↩︎

  4. www.bankofengland.co.uk/-/media/boe/files/speech/2023/november/recent-uk-inflation-an-application-of-the-bernanke-blanchard-model-paper.pdf.↩︎

  5. www.bis.org/publ/qtrpdf/r_qt2312f.pdf.↩︎

  6. See thenextrecession.wordpress.com/2022/04/18/the-inflation-debate.↩︎

  7. As previously argued. See thenextrecession.wordpress.com/2024/03/18/profits-margins-and-rates.↩︎

  8. See thenextrecession.wordpress.com/2023/11/12/from-a-sahm-recession-to-global-downturn.↩︎

  9. thenextrecession.wordpress.com/2024/03/13/us-economy-saved-by-immigrants.↩︎