At non-financial corporate businesses, the level of checkable deposits and currency has been growing rapidly, as Figure 7 shows. This could represent a form of “scarring” from the recession if it means that firms are less confident in raising funds from the market or financial intermediaries, and are now essentially more risk-averse and banking cash. While some risk aversion is clearly vital, a growing degree of risk aversion among non-financial corporate businesses may signal subdued investment behavior by firms – behavior that would, on net, lead to slower economic growth.

Incidentally, despite what some critics have said, this benign outcome for inflation is actually quite consistent with my reading of Milton Friedman’s analysis. The measures of money he associated with inflation were broad measures that include money created by the banking system. The increases we have seen in those measures have been much more moderate. One of the big points from his Monetary History of the United States[3] was that focusing too much on the size of the Fed’s balance sheet was a bad idea. Indeed, in the early 1930s, the Fed increased the size of its balance sheet quite substantially. But it wasn’t enough. Given the struggles of the banking system, broad measures of money actually declined, leading to deflation. The conclusion was that the Fed needed to have increased its balance sheet even more. That’s a lesson the Bernanke Fed has taken to heart this time around.

Many have read the FOMC statement as virtually guaranteeing that the Fed will hold the funds rate near zero for at least another two years, but Lacker said that is not a valid interpretation. “I would note that it’s a fairly mild statement in the sense that it’s highly contingent,” he said... “I think that if the economic data come in differently than the Committee expected then I think that will provide the opportunity to alter the terms of that statement.” 

 “That statement isn’t so much a commitment as it is a forecast,” he added.

...

Lacker said his main objection to the extended zero rate policy is directed elsewhere: “For me predominantly, it’s a matter of money creation and inflation.”

 “We operate monetary policy by moving short-term interest rates around over the business cycle,” he explained. “We do that because what’s required to get the money supply right, to keep inflation low and stable, a lower interest rate is required when the economy is soft, and a higher interest rate is required when the economy is strong.” “If we get the interest rate wrong we’re going to get the money supply wrong, and that’s going to get inflation wrong,” he continued. “And that’s why we vary interest rates with economic conditions the way we do. People confuse that with providing stimulus and working to offset shocks to growth, positive or negative.” 

 “So for me the chief risk is that it creates the ingredients for an acceleration of inflation.”

Finally, as an element of a framework for the near term, I want to push the notion of a renewed focus on monetary and credit aggregates. The anxiety about the large size of the Fed's balance sheet revolves around fear that reserves currently idle on bank balance sheets will suddenly come off the sidelines. If those balances get in the game faster than the economy can absorb them, there might be serious inflationary consequences.

Practically speaking, I find it hard to imagine circumstances in which the credit channel would heat up so fast and in such volume that broad money creation would get away from the Fed's capability to drain liquidity. But precautionary monitoring is certainly warranted.

In recent history, there has not been much attention put on monetary aggregates. I would argue this is not because economists and policymakers have abandoned belief in the fundamental long-run relationship between money and inflation. Instead, monetary measures have not factored into policy discussions for quite some time because fluctuations in money multipliers and velocity made broad measurement elusive. Financial innovation has been such a force that forecasting methodology based on the money-price level growth connection came to be viewed as unreliable for policymaking.

It's worth remembering, however, that it was Paul Volcker's return to a focus on money growth that led the way to defeating the Great Inflation. The Volcker Fed's success set the stage for an extended period of controlled inflation approaching three decades.

BERNANKE: Well, first, I think that many of the monetary or nominal indicators that somebody like Milton Friedman would look at did suggest the need for more monetary stimulus. For example, nominal GDP has grown very slowly. Growth in the money supply is a fact -- not talking about the reserves held by banks, which are basically idle, but if you look at M1 and M2, those have grown pretty slowly.
The Taylor rule suggests that we should be in some sense way below zero in our interest rate and therefore we need some method other than just normal interest rate changes to -- to...

TOOMEY: Do you know if Mr. Taylor believes that?

BERNANKE: Well, there are different versions of the Taylor rule. And there's no particular reason to pick the one he picked in 1993. In fact, he preferred a different one in 1999, which if you use that one gives you a much different answer.

TOOMEY: My understanding is that his view of his own rule is that it would call for a higher fed funds rate than what we have now.

BERNANKE: There are, again, many ways of looking at that rule, and I think that ones that look at history, ones that are justified by modeling analysis, many of them suggest that we are -- we should be well below zero, and I just would disagree that that's the only way to look at it. But, anyway, so I think there are some -- there is some basis for -- for -- for doing that.
I'm sorry, the last part of your question was?

TOOMEY: In the context of even, unfortunately, slow economic growth, should that persist, what kind of inflation indications would cause you...

BERNANKE: ... we are very -- we are -- we are committed -- you know, some -- some economists have -- a few economists have suggested temporarily raising inflation above normal levels in order to -- as a way of trying to stimulate the economy. We have rejected that approach, and we are committed to not letting inflation go above sort of the normal level of around 2 percent in the medium term.

So we are looking very carefully at indicators of inflation, including actual inflation, including commodity prices, including the spreads between nominal and index bonds, which is a measure of inflation compensation, looking at surveys, business pricing plans, household inflation expectations. We look at a whole variety of things.  And we -- I just want to assure you, we take the inflation issue very, very seriously, and we do not have the illusion that allowing inflation to get high is in any way a constructive thing to do. And we are not going to do that.

[I]n a 2006 speech about the historic use of monetary aggregates in setting Federal Reserve policy, Chairman Bernanke pointed out that, "in practice, the difficulty has been that, in the United States, deregulation, financial innovation, and other factors have led to recurrent instability in the relationships between various monetary aggregates and other nominal variables." Still, my colleagues and I will be monitoring a wide range of financial and economic developments very closely -- including the growth of the money supply, inflation, and many other financial and nonfinancial variables -- and, based on a full assessment of those developments, the FOMC will withdraw monetary accommodation at the appropriate time. My view is that the elevated reserve balances would be inflationary only if they prevented the FOMC from effectively removing monetary accommodation by raising interest rates when the time comes to remove such accommodation, and I am convinced that that will not be the case.

It is well known and widely understood that, over the medium to long run, inflation reflects the growth rate of money. The current environment of exceptionally low short-term nominal interest rates does not prevent a central bank from increasing the money supply. In this sense, stabilization policy goals can be accomplished through influence on the expected rate of inflation.

...In the United States, the size of the monetary base doubled over a four-month period beginning in September 2008. This increase is astonishingly large. However, the increase in the base is in part a byproduct of Federal Reserve programs to assist credit markets and carry out its lender-of-last-resort function...  Temporary increases in the monetary base—here one day, gone the next—would not be expected to have an important influence on the rate of inflation. Therefore, we shall have to segregate the temporary increases in the monetary base associated with lender-of-last-resort programs from the more persistent increases in the monetary base associated with outright purchases of Treasury securities, agency mortgage-backed securities and agency debt. It is the persistent increases in the monetary base that should properly be expected to influence the rate of inflation and therefore have an influence on inflation expectations and real interest rates.

Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed's lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base.  However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base.² At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

[2. ]  M1 consists of currency, traveler's checks, demand deposits, and other checkable deposits. M2 consists of M1 plus savings deposits, small-denomination time deposits, and balances in retail money market mutual funds. M2 has grown more rapidly than normal in recent months, at about a 15 percent annual rate on a quarterly average basis in the fourth quarter. We attribute this increase primarily to investors' demand for greater safety, which has led them to increase their holdings of government-guaranteed bank deposits. We expect growth in M2 to slow considerably in 2009, barring a similar shift in portfolio preferences. Return to text]

[W]hile the monetary base has expanded at an extraordinarily fast pace during the fall and winter, much of that expansion has been closely related to the Fed’s lender-of-last-resort function, and cannot be counted on to keep expectations of disinflation and deflation at bay. Because of this, the Fed needs a more systematic method of keeping the persistent component of monetary base growth rates elevated in order to combat the risk of a deflationary trap.

…

“As I have discussed, the Fed’s balance sheet has grown at an astounding rate since September of last year, and the monetary base has more than doubled. But the new, temporary, lender-of-last-resort programs are blurring the meaning of this picture. A temporary increase in the monetary base, by itself, would not normally be considered inflationary. The increase would have to be expected to be sustained in the future in order to have an impact. Much, but not all, of the recent increase in the balance sheet can reasonably be viewed as temporary. The outright purchases of agency debt and MBS are likely to be more persistent, however, and it is these purchases that may provide enough expansion in the monetary base to offset the risk of further disinflation and possible deflation. The quantitative effects of policy actions in this new environment are more uncertain than normal, but nevertheless these less-conventional policies can have every bit as powerful an impact on the economy as changes in the intended federal funds rate.

I do not believe that deflation is a major risk right now. But deflation can be dangerous because for any given interest rate, it increases the corresponding real (or inflation-adjusted) interest rate, and thus stifles growth. For a sustained deflation to emerge, people have to believe that the money supply will fall along with the price level.  That's what happened during the first three years of the 1930s, at the beginning of the Great Depression, when the U.S. consumer price index fell by 27 percent, and the monetary base shrank by 28 percent. Central banks can prevent deflation by credibly committing to keep the money supply from contracting. Such a commitment is a natural byproduct of a credible commitment to price stability, but for a central bank that has not yet formally adopted an inflation objective, preventing deflation can present additional challenges. This is why some central banks increase the quantity of their monetary liabilities dramatically when interest rates are at zero — to convince the public they will not let the money supply contract in the future.

In response to a question about an ultra-low rate policy:

"I have not been a fan of going to really low levels," Bullard said today in a Bloomberg Television interview.  "Why is it zero this time?  I don't quite get that, though I know some people want to go in that direction."

In response to a question about the implications of the slowdown in money supply growth:

 “If you want to go to quantitative measures, then all of the issues about money come back to haunt you.  You have to talk about velocity and shocks to velocity, and you have to think about all the other things that are going on.  That is a debate that existed in the Eighties and probably sort of petered out in the Nineties, but it might be re-merging now.  But I don’t know exactly how the Fed is going to play that going forward.”

 In response to a question about quantitative easing and unconventional methods.

 “I think these issues are being discussed right now, and I don’t know how it’s all going to come out. I will point out that you have the 1979-82 period and there the famous monetarist experiment, for those of your viewers that were around at that time.  And in that case, gave up interest rate targeting, went to quantity targeting, lots of controversy about exactly how that worked and so and so forth, so it’s been done before.  And you could do it again.”

 “I think the Fed has plenty of tools that we can use.  One of the main things that I’m concerned about is somehow we can communicate what we’re going to do to a private sector that is used to thinking in terms of interest rates, because for the time being it looks like that is going to be off the table for a while.”

The idea that monetary policy should be conducted in a systematic and predictable way is not new. One of the earliest, and most controversial, proposals was Milton Friedman’s famous k-percent money growth rule.2 Friedman argued that monetary policy was a major contributor to cyclical fluctuations. He argued that efforts by the central bank to “stabilize” or “fine-tune” the real economy were fraught with danger because we didn’t know enough about the short-run dynamics of monetary actions to reliably predict their effects on the real economy. As a result, monetary policy ended up being a source of real instability rather than a stabilizing influence.

In addition, Friedman correctly argued that sustained inflation was always a monetary phenomenon and that in a world of paper or fiat money, the central bank had the obligation to preserve money’s purchasing power so that markets would not be distorted by inflation. Price stability would therefore promote a more efficient allocation of resources. At the time, this view of the importance of price stability was controversial, but today it is widely accepted.

Thus, Friedman highlighted two central features of good monetary policy that are hallmarks of the rules that I will turn to shortly. First, he argued that monetary policy should be formulated in a way that stabilized the purchasing power of money. Second, he stressed monetary policy should not be used to “fine-tune” real economic activity because attempting to do so often introduced instability into the real economy instead of improving economic performance. His actual proposal was that the Federal Reserve should announce that the money supply would be allowed to grow at k-percent a year -- period. With k a suitably low number, such a policy rule would ensure that inflation would never become a problem and that monetary policy would cease to be an independent source of cyclical fluctuations.

The Friedman rule is simple and easy to communicate. It also gives a high degree of predictability to monetary policy. Had it been implemented, it surely would have prevented the double-digit inflation the U.S. economy suffered in the late 1970s, as well as much of the subsequent economic disruptions in the early 1980s that occurred as inflation was brought back down to acceptable levels.

Yet the rule has several shortcomings that have limited its appeal. Most important, many economists view money demand as volatile, so that a constant supply of money could lead to more variability in inflation, and perhaps output, than necessary. Thus, most economists believe that some sort of policy that responds to the state of the economy could perform better.

BERNANKE: Well, Congressman, first, just a small technical point. On the growth in money, money growth has been pretty moderate over the last few years. The increase in MZM is probably related to the financial turmoil. People have been taking their savings out of, you know, risky assets, putting them into the bank, and that makes the money data show faster growth.

So I'm not sure that's indicative of policy, necessarily.

From the Q&A session

David suggests that monetarism failed when its proponents got too prescriptive by advocating rigid rules for money growth.  Among the lessons he takes from the failed monetarist experiment are that central banking is an applied science and that our imperfect understanding of how economies and markets function implies that a good dose of humility is required--and I agree. 

Over time, this research, as well as Friedman's predictions that expansionary monetary policy in the 1960s would lead to high inflation and high interest rates (Friedman, 1968), had a major impact on the economics profession, with almost all economists eventually coming to agree with the Friedman's famous adage, "Inflation is always and everywhere a monetary phenomenon" (Friedman 1963, p. 17), as long as inflation is referring to a sustained increase in the price level (e.g., Mishkin, 2007a).

General agreement with Friedman's adage did not mean that all economists subscribed to the view that the money growth was the most informative piece of information about inflation, but rather that the ultimate source of inflation was overly expansionary monetary policy. In particular, an important imprint of this line of thought was that central bankers came to recognize that keeping inflation under control was their responsibility.