The Federal Reserve Bank of Richmond alerted me to a newish paper from one of my favourite economists, Robert Hetzel, entitled “The Monetarist-Keynesian Debate and the Phillips Curve: Lessons from the Great Inflation”—needless to say it’s highly interesting and informative. One bit in particular prompted me to write this screed on neutrality in central banking and monetary policy.

In the Keynesian tradition, cyclical fluctuations arise from real shocks in the form of discrete shifts in the degree of investor optimism and pessimism about the future large enough to overwhelm the stabilising properties of the price system and, by extension, to overwhelm the monetary stimulus evidenced by cyclically low interest rates.

In the quantity theory [monetarist] tradition, cyclical fluctations rise from central bank behaviour that frustrates the working of the price system through monetary shocks that require changes in individual relative prices to reach, on average, a new price level in a way uncoordinated by a common set of expectations.

In the real-business-cycle [new classical] tradition, cyclical fluctuations arise from productivity shocks passed on to the real economy through a well-functioning price system devoid of monetary non-neutralities and nominal price stickiness.

From each of these perspectives, we can derive some sort of definition of monetary/central bank neutrality, as well as an idea of what policy the central bank should operate. It strikes me that only one view is plausible, but before I make the case for that view, I will make the case for a particular theory of “meta-neutrality”, i.e. a way that we should think about neutrality, whatever our perspective. I think this is something that everyone should be able to agree on, but I think that once we’ve agreed on it one view becomes inescapable.

Nothing is neutral with respect to everything. In one of my favourite ever essays, Scott Alexander makes a very similar point about “safe spaces” (nothing can be a safe space for everything—safe spaces for, e.g. a safe space for a disadvantaged group cannot also be a safe space for no-holds-barred rational discussion). In the same way, a monetary policy that is neutral with respect to real interest rates might conceivably have to achieve this by non-neutrality with respect to say, exchange rates. So the interesting question is what economic variables monetary policy must be neutral with respect to for us to call it “neutral” with no qualifiers.

But what we really want to be neutral to is the microeconomic working of the price system and markets generally, which is a bit more complex than any particular macroeconomic variable we could point to. One way around the question is by thinking about what might be non-neutral to the workings of the price system. One answer is: menu and shoe-leather costs, typically associated with high inflation, but more accurately linked to high aggregate demand (nominal GDP) growth.

Both impose restrictions on price adjustment, especially if they are unexpected and hence not “priced in”.Menu costs will stop firms re-pricing things as often as would be optimal, impeding price adjustment, whileshoe-leather costs (from the high nominal interest rates associated with high inflation and high NGDP growth) will stop people from holding as much cash as they otherwise would, distorting their consumption decisions.

On the other side, unexpectedly low NGDP growth, combined with “money illusion” in borrowers (“sticky debts”) and workers (“sticky wages”), could cause other microeconomic problems—markets won’t clear until people’s information, expectations and plans have adjusted, i.e. until people realise that the fall in prices/wages is not a relative price adjustment but a fall in overall prices/NGDP.

Overall this suggests we should call a policy neutral without qualifiers not when it is perfectly neutral (which is impossible) but when it is the “neutrality maximising policy”. In the words of David Beckworth “neither too stimulative nor too contractionary and is pushing the economy toward its full potential” or in the words of Alan Greenspan one that “would keep the economy at its production potential over time”.

That is, one that balances the distortionary costs of high (particularly unexpectedly high) NGDP growth with the costs of low (particularly unexpectedly low) NGDP growth. Empirically, menu cost and shoe leather problems have never been large in the USA and UK when NGDP is ticking along at about 5%. By contrast, NGDP growth less than 2.5% is almost always consonant with stagnation, while NGDP growth of less than zero always means a recession—much bigger costs. This suggests policy, far from being unprecedentedly easy in the lacklustre post-recession recovery, was if anything on the tight side of neutral.

Two crucial final points:

1. Identifying the conditions that we’d want to see in the macroeconomy for a (relatively) undistorted microeconomy does not mean endorsing a particular monetary arrangement or regime. Whether we have a central bank or not, we’d want stable NGDP growth.

2. This 5% level is contingent on society-wide expectations. If long-term expectations held by borrowers, lenders, firms, consumers and workers were for 0% NGDP growth (e.g. the 19th Century), then 0% NGDP growth would be more likely to be the neutrality-maximising monetary policy.