Milton Friedman was Wrong. Inflation is Not Always a Monetary Phenomenon

I have a lot of respect for the late Milton Friedman. I really do. His unapologetic defense of the free market was–and still is–a breath of fresh air amidst the constant drone of calls for the government to “do something” to fix all of our problems, real or imagined.

But on the subject of inflation–the subject on which Friedman is most often quoted–he was dead wrong. Inflation is not “always and everywhere a monetary phenomenon.” Other factors–such as demographic change–can and do overwhelm central bank monetary policy when they reach extremes. I tackled this subject two years ago in a piece that tied Japan’s chronic deflation to its aging and shrinking population.

I’m not the only voice in the wilderness. Harry Dent has made the same basic demographic arguments for over twenty years, and his views have gone a long way to shaping my own here. And now, the Fed appears to be coming around. Earlier this year, the Richmond Fed published a piece that asks: Will the Graying of America Change Monetary Policy?

Here is an excerpt:

Despite the certainty of the oncoming demographic change, little is known about how it is likely to affect the Fed’s policy tools. Some policymakers and observers have expressed concern, however, that the Fed’s ability to stimulate the economy may decline for demographic reasons, if it hasn’t already done so. For example, New York Fed President William Dudley suggested in a 2012 speech that “demographic factors have played a role in restraining the recovery,” [emphasis mine] in part because spending by older Americans is “less likely to be easily stimulated by monetary policy.”

It’s called “pushing on a string,” and it’s something I addressed recently in an article on secular stagnation. Keeping interest rates artificially suppressed will not encourage older Americans to buy more on credit. In retirement, most of us trade down to smaller homes rather than trade up. We also drive less and thus replace our cars less often. And we already own all of the big-ticket items that consumers generally buy on credit, such as furniture and appliances. So, the older a society becomes, the less effective monetary policy is in spurring consumption.

Need evidence? Look east to Japan. The Bank of Japan has had some of the loosest monetary policy in the world for the better part of two decades, and they stepped it up several notches recently with an expansion of their quantitative easing program in October. A program which was, by the way, already the largest in the world. Thus far, it’s all been for naught. Japan is officially in recession again.

So, what does the Richmond Fed see going forward? In short, the Fed will get a lot less bang for its buck with traditional monetary policy. The Fed may be forced to make “bigger interest rate changes for the same amount of stimulus or tightening it wishes to apply to the economy.”  Or it could be forced to revisit large-scale bond-buying (i.e. “quantitative easing”) programs again. The Fed wrapped up “QE Infinity” in October.

I’ve been talking in generalities. Let’s drill down to some real numbers. The Richmond Fed continues,

It’s challenging to reach firm empirical conclusions in this area because demographic change is slow. One such effort, by Imam of the IMF, studied the effect of monetary policy shocks on inflation and unemployment in the United States, Canada, Japan, the United Kingdom, and Germany and found that their effect has decreased over time. Imam further looked at whether this effect was associated with the timing of the aging of those societies and found “quite a strong negative long-run effect of the aging of the population on the effectiveness of monetary policy…” He determined that a 1 percentage point increase in the old-age dependency ratio reduces the effect of such an interest-rate change on inflation by 0.1 percentage point and its effect on the unemployment rate by 0.35 percentage point.

The Census Bureau estimates that the old-age dependency ratio in the United States will rise by 14 percentage points from 2010 to 2030. If Imam’s estimates and the Census Bureau’s estimates were to hold, they would imply a 1.4 percentage point drop in the Fed’s ability to affect inflation and a 4.9 percentage point drop in its ability to affect unemployment. Over the course of a 20-year period, such a change might be perceived as modest from one year to another, but cumulatively it would amount to a strong negative effect indeed.

I should also point out that all of this assumes we’re in a “normal” interest rate environment. The target Fed funds rate is still at 0%, and the 10-year Treasury yields 2.2%. If we were to follow Europe and Japan into another recession–even a mild one–the Fed has almost nothing in the way of policy tools to draw on. Pushing longer term yields from 2.2% to, say, 1.0% just isn’t going to make that big of a difference.