Clark Warburton, in Depression, Inflation, and Monetary Policy (1966), contended that “the guiding principles for Federal Reserve action in the Federal Reserve Act, both in its original form and in amendments, are vague and ambiguous, and Federal Reserve officials and staff developed an ambiguous terminology, resulting in confusion as to the proper kind of guide for central bank action” (p. 343). His concern is still relevant today. Although the Fed has a dual mandate to achieve maximum employment and price stability, there is no clear rule that policymakers follow, and no one is held accountable for not meeting those objectives.

Central bankers need a clear guide to monetary policy—and that guide can’t be the price of credit, which should be determined in free capital markets, not by government officials. Most importantly, in a pure fiat money regime, there needs to be a credible, transparent rule for the conduct of monetary policy that ensures stable money—that is, a rule that prevents stop-go policy and preserves, as much as possible, monetary equilibrium (see, e.g., Schuler 2011 and Selgin 1990).

Interest Rates Are a Poor Guide to Monetary Policy

In “The Counter-Revolution in Monetary Theory,” Friedman (1983) argued that “interest rates are a highly misleading guide to monetary policy.” An excess supply of money will initially increase asset prices and decrease yields (interest rates). However, eventually, the excess money (cash balances) will increase incomes and spending, push the average level of money prices upward (i.e., produce price inflation), raise the nominal demand for loanable funds, and push nominal interest rates up. The opposite is true in the case of monetary deficiency (i.e., an excess demand for money). In sum, the relation between money and interest rates is not uniform—interest rates could, for example, rise because monetary policy has been too loose or too tight—and is a poor guide to the stance of monetary policy (see Friedman 1983: 24–25).

Likewise, Warburton (1966) concluded “that monetary policy should be concerned, not with the rate of interest per se, but with the maintenance of a suitable quantity of money” to avoid both inflation and depression (p. 101). He reached this conclusion by drawing on his own statistical analysis informed by “orthodox theory.”

In particular, Warburton (1966: 90) recognized that:

The interest theory developed in the nineteenth century and accepted in early twentieth-century theory, like price theory, had two main subdivisions: first, a theory of a natural [equilibrium] rate determined by the demand for and supply of loans under the condition of monetary stability, and with the demand influenced primarily by prospective profits and the supply by savings offered for loans, and, second, a theory regarding departures from the natural rate induced by changes in the quantity of money.

Warburton challenged contemporary thought regarding the “identification of monetary policy with interest-rate manipulation” (p. 96). He insisted that “changes in interest rates” can’t “be depended on as a guide to monetary policy” (p. 290). His key argument is that:

In order for interest rate changes to be used successfully as a criterion for central bank action they must somehow be used in a manner to produce a monetary growth in accord with the need for money generated by growth of population, growth in production per capita, and increased holdings of cash reserves by individuals and business. Interest rates cannot be so used because the rate of interest must be free to respond to real changes in the demand and supply of loan funds, in order to avoid producing monetary maladjustment, and there is no method of judging accurately the “correct” level of interest rates except when monetary maladjustment is avoided [Warburton 1966: 290].

In sum, interest rates are best left to free markets. They are relative prices that reflect tradeoffs between present and future consumption, and thus depend on consumers’ time preferences as well as on the productivity of capital. A central bank that tries to use interest rates, rather than the quantity of money, to guide monetary policy is prone to create monetary disequilibrium and distort interest rates away from their natural, market-determined levels—misallocating capital in the process. This is what Warburton (1966: 233) called “upside-down monetary policy.”

Creating a Harmonious Monetary Order

In the search for stable money, it is critical to distinguish clearly between the demand for money and the demand for credit. When there is an excess demand for money, individuals and businesses will adjust their cash balances: they will hold more cash and reduce their expenditures in a myriad of markets—ultimately affecting the general level of money prices. In contrast, a change in the demand for credit will lead to an increase in the price of credit—that is, the interest rate (see Yeager 1997: 107). That is why Leland Yeager is so adamant in arguing that “no other excess demand could be as … disruptive as an excess demand for money” (p. 106).

Because of the unique characteristics of money, especially its function as a generally accepted medium of exchange, an excess demand or supply of money, in a world of price rigidities, can disrupt the smooth operation of a market price system. In particular, as Yeager (1997: 192) notes, “The supply of and demand for money [cash balances] interact … to determine the nominal flow of spending and eventually the purchasing power of the monetary unit.” Consequently, “anything that shrinks the flow of money interferes—barring complete price flexibility—with the exchange of goods and services” (p. 107). Creating a harmonious monetary order is therefore paramount.

One of Warburton’s chief contributions to monetary theory was to show that the fundamental cause of the Great Depression was monetary disorder. He came to that conclusion well before Friedman and Schwartz in their Monetary History of the United States (1963).

There is no monetary rule that will automatically bring the demand for and supply of money in balance to restore monetary equilibrium. Nevertheless, in a fiat money regime, a rule-based money policy is more likely to reduce uncertainty about the flow of nominal income and the long-run value of money. In doing so, a monetary rule, as opposed to pure discretion, is likely to diminish monetary disorder and create both a harmonious monetary system and help markets more efficiently allocate scarce resources. In particular, stable money will improve long-run investment decisions and thus provide a positive environment for wealth creation.

There are a number of monetary rules one could consider. Milton Friedman, in Dollars and Deficits (1968), argues against a price-level rule in favor of a constant money-growth rule. He thinks that a rule aimed at achieving price stability “is the wrong kind of rule because the objectives it specifies are ones that the monetary authorities do not have the clear and direct power to achieve by their own actions” (Friedman 1968: 193). Although he sees “a close connection” between money and prices, he argues that “the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities.”

In selecting a money-growth rule, Friedman (1968) suggested that the Fed should keep the narrowly defined money supply (i.e., currency held by the public plus commercial bank deposits) growing at a rate of 3 to 5 percent. However, he did not consider this rule “a be-all and end-all of monetary management”—that is, as a rule which is somehow to be written in tables of gold and enshrined for all future time” (pp. 193–94). Friedman (1968) concludes that, although his rule is not perfect, given the state of knowledge at the time, it would offer “the greatest promise of achieving a reasonable degree of monetary stability.”

Friedman hoped that, over time, “as we learned more about monetary matters, we might be able to devise still better rules which would achieve still better results” (p. 194). The key point, however, is that Friedman saw a rules-based monetary regime as “the only feasible device currently available for converting monetary policy into a pillar of a free society rather than a threat to its foundations.”

One thing we have learned is that a constant money growth rule is inferior to a velocity-adjusted monetary rule, designed to maintain a target path for NGDP and achieve long-run price stability (see, e.g., Dorn 2022 and the references therein). Warburton had such a rule in mind when, in 1953, he wrote:

The most appropriate rule of action for the monetary authorities is that of maintaining a rate of growth in the quantity of the circulating medium which will compare with the general rate of growth in the total output of final products under conditions of “full employment,” with such adjustments as may be needed on account of (1) observed trend in the rate of use of circulating medium for purchase of final products, (2) seasonal variations, and (3) any other conditions which have been demonstrated to require variations from the calculated line of growth in the quantity of money in order to maintain stability of prices of final products [in Warburton 1966: 377].

Increasing interest in NGDP targeting is something both Friedman and Warburton would likely approve of, in the quest for a rules-based monetary regime.

Conclusion

The current inflation has focused attention on monetary policy and the search for monetary order. Focusing monetary policy on interest rates (i.e., the price of credit) is a poor guide for achieving a harmonious monetary order. What Warburton wrote in 1966 remains true today: “There is still an overemphasis on manipulation or control, or exertion of pressure on, interest rates as a means of exercising governmental influence over aggregate demand or major sections of such demand” (p. 16).

Today, the Fed (or more correctly, the Board of Governors) conducts monetary policy by administering two key interest rates—namely, the rate paid on reserves held at the Fed and the overnight reverse repo rate. Until recently, those rates have been kept near zero, leading to sharply negative real rates as inflation has reached a forty-year high.

In a fiat monetary regime characterized by discretionary government management, the likelihood of monetary disorder increases compared to a rules-based regime. The Fed and Congress need to listen to those who propose monetary alternatives based on rules rather than discretion (see, e.g., the essays in Dorn 2017). Attention should turn away from the day-to-day operation of the Fed and focus on fundamental guiding principles and learning from past mistakes.