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Did Market Monetarists Accurately Predict Low Inflation?

David Beckworth stated on Twitter that Market Monetarists “knew all along inflation would not be a problem”.  It’s true.  The Market Monetarists have long been predicting low inflation and even deflation.   See this 2009 piece by Scott Sumner titled “Deflation is our Biggest Worry – Not Inflation”.  So yes, the Market Monetarists nailed this one, right?  Not so fast.

If you read the actual 2009 article you see the reasoning behind the thinking:

“Banks kept the Fed’s cash
Other economists point to the Fed’s large injections of cash into the banking system as an inflationary “time bomb.” But last October the Fed began a policy of paying interest on those extra bank reserves in order to keep interest rates from immediately falling to zero. Unfortunately, this caused banks to hoard the money, which is why prices have fallen over the past 12 months despite the Fed’s large injections of cash.”

Sumner followed that up a few weeks later with an even clearer explanation:

“Ohanian points out that the Fed has done a lot already, having increased bank reserves from $40 billion to $900 billion. But this liquidity injection was not what it seems — indeed, if it was, we’d now have hyperinflation. In reality, the Fed completely neutralized the injection by starting a new policy of paying interest on reserves, causing banks to simply hoard these “excess reserves,” instead of lending them out. The money never made it out into the economy, so it did not stimulate demand.”

This is obviously a misinterpretation of the money multiplier and it’s based on an incorrect causal understanding of bank reserves and the lending process.   More recently, there’s been some revisionist history on this concept.  Obviously, the 2009 Scott Sumner believed in the Money Multiplier and the myth that banks “lend out” reserves.  But since the Bank of England demolished that myth the story changed.  2014 Scott Sumner says the Money Multiplier is still valid, but simply represents a ratio instead of a causal relationship in the lending process.

So I don’t think the victory flag can be so triumphantly waved here.  I don’t doubt David’s claim that the Market Monetarists thought the Fed was too tight and that they weren’t doing enough to generate high inflation.  In fact, I think David is undoubtedly correct there.  But it’s also crystal clear that some other components of the reasoning for low inflation were based on a total misunderstanding of how modern banking works.  And so the conclusions were right, but not entirely for the right reasons.   And this again, proves why understanding the modern monetary system is so important.  


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