The Fed Needs to Put Its Eye on the Money Supply

Slowing its growth without triggering a recession is a tricky proposition. Is the central bank up for it?

By John Greenwood and Steve H. Hanke. Excerpts:

"Why was the FOMC and market consensus caught so flat-footed? And what can be done to prevent this kind of mistake going forward?

Fundamentally, two things need fixing: the Fed’s current modus operandi and widely held but mistaken views about how the Fed and the banking system interact to create inflation.

Ask Fed officers or observers how monetary policy works, and they’ll tell you it’s all about interest rates. Hence, the laser focus on the series of projected rate hikes later this year. But the reality is different. When it comes to inflation, what really matters isn’t so much the level of rates but what they imply for money growth. As Milton Friedman once observed, “Monetary policy is not about interest rates; it is about the growth of the quantity of [broad] money.”

The true source of the current inflation is the cumulative increase in the money supply measured by M2 since February 2020—an incredible 41.2%. In January the rate of growth of M2, even after three months of tapering bond purchases by the Fed, was still 12.6% over its level a year earlier. That’s about double the rate it needs to be to hit the Fed’s 2% inflation target."

How should the Fed calibrate fed-funds rate increases? Ideally, the Fed needs to be sure that it raises rates sufficiently to slow monetary growth on a gradual and steady basis to a growth rate of around 5% to 6%. This would be consistent with 2% inflation, as it was between 2010 and 2019. But to hit this golden growth rate, the Fed must avoid two potential pitfalls.

The Fed could fail to raise rates enough, thereby giving banks and their customers an incentive to create excess credit. Given the surging demand for credit in a strengthening economy with rising inflation expectations, we could end the year with monetary growth still at its current excessive rate. That would mean that the current 7.9% inflation rate would persist not only this year but through 2023 and into 2024. To rein in inflation, the Fed needs to get out in front of the surge in demand for credit as the Bank of Japan did ahead of the second oil crisis in 1979-80.

The Fed also needs to be sure not to err too much in the other direction. If the Fed raises rates so much that the demand for loans evaporates, new deposit creation will plummet, and monetary growth will slump. With that, the Fed will have precipitated a recession as Paul Volcker did in 1980-81.

During the pandemic, the Fed made a colossal error by ignoring the growth rate in the money supply and creating a massive amount of excess money. The Fed must now slow money growth, but not too much to trigger a recession. To do that, the Fed has to put the money supply on its dashboard. At present it’s absent, which means the Fed is flying blind."