The comeback of money in Monetary Policy

By: Wolfgang Munchau

If there is one area where Europeans are from Mars and Americans from Venus, it is monetary policy and the role of monetary aggregates.

Last week, the world's two most prominent central bankers publicly disagreed. Jean-Claude Trichet, European Central Bank president, argued in the Financial Times why monetary analysis would remain an essential part of the ECB's tool kit. Ben Bernanke, US Federal Reserve chairman, said a central bank would be unwise to rely too heavily on money since financial innovation had been causing disturbances to monetary statistics.

It seems at first like an ancient Keynesian-versus-monetarist debate but this is not so. For a start, this is about the role of money, not monetarism, the theory that postulated that central banks should target the money supply to stabilise inflation over the medium term. Even the ECB does not go that far. Monetarism did – and still does – suffer from the devastating critique of Goodhart's Law, which says that the predictable relationship between money and inflation breaks down when policymakers start to exploit it.

Mr Trichet and colleagues believe that a careful analysis of monetary conditions – the so-called second pillar of ECB strategy – carries important signals. Like other central banks, the ECB forms a view about the future on the basis of an economic forecast but, unlike most others, it uses monetary analysis as a cross-check.

Most – but not all – of the academic community is behind Mr Bernanke. At an ECB conference last week, Michael Woodford, a monetary economist from Columbia University, made a powerful case against money.* He said there was no need for a separate monetary analysis. The so-called neo-Keynesian economic models, which included no reference to money, delivered all the information central bankers needed to judge future price pressures. This type of model is consistent with everything conservative central bankers believe: that inflation is ultimately a monetary phenomenon and that money is neutral in the long run, which means it does not create long-run growth. The implication is that a second pillar is redundant at best.

But there are good arguments against a total exorcism of money. One comes from none other than Professor Charles Goodhart. Speaking this year, he suggested an interesting corollary to his famous law: since central banks gave up targeting the money supply many years ago, should we not expect the relationship between money and inflation to stabilise once again?**

Those in favour of a separate monetary analysis assign an important role to the transmission channels of monetary policy, such as bank lending or the financial markets. Lawrence Christiano from Northwestern University and Roberto Motto and Massimo Rostagno, both from the ECB, have argued that the traditional neo-Keynesian models cannot conceivably explain the strength of the boom-bust cycles in stock markets. For that to happen, money is essential.*

Suppose that people are unduly optimistic about a new technology. Companies hire staff and expand production. In a world with inflexible wages, companies create excess capacity but wages do not rise sufficiently fast. The result is that inflation falls. An inflation-targeting central bank would be forced to cut interest rates under these circumstances, which would lead to even more investment. In this model, monetary policy is directly responsible for creating a boom-bust cycle.
This debate is far from concluded. My own sense is that money will probably make some form of a comeback, perhaps not as an explicit policy pillar and certainly not as a 21st century version of monetarism. But the way financial markets are evolving, it may be unwise for central bankers to throw away the key to monetary analysis altogether.

* Both papers available from www.ecb.int/events/conferences/html/cbc4.en.html

** The ECB and the Conduct of Monetary Policy: Goodhart's Law and Lessons from the Eurozone, Lecture, European Institute, London School of Economics, February 2006

©The Financial Times Limited 2006