About the author: Robert Heller is a former member of the Board of Governors of the Federal Reserve System.
Inflation is the most important issue facing the economy today, according to the most recent Gallup poll. Congress gave the Federal Reserve the mandate to maintain “stable prices” along with “maximum employment.” That is the so-called dual mandate, which puts the Fed in charge of the nation’s monetary policy.
Milton Friedman, Nobel Prize winner and probably the best-known monetary economist of all time, said famously, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
One might assume that controlling the quantity of money should be a key mission of the Federal Reserve. But that is no longer the case. If you look at the official Federal Open Market Committee Statements published after each FOMC meeting for the last three years, you will search in vain for the word “money.” It is not even mentioned a single time in all these years.
That was not always true. When Paul Volcker was in charge of the Fed in the 1980s, the Fed considered controlling and steering the money supply to be its most important policy tool. During the 1990s, the velocity of the broadly defined money supply, M2, increased as money market funds and other near-money substitutes were introduced. But this trend in the velocity of money was reversed in the years since 2000 and now monetary velocity is even below what it was in the Volcker years.
While there are certain measurement issues that should certainly be considered, it would be folly not to look at the money supply at all as a key determinant of inflationary pressures. But that seems to be the current policy stance of the Fed.
Even a casual inspection of the graphs showing the growth rate of the money supply as measured by M2 and the inflation rate as reflected in the consumer price index reveals that the correlation between money and prices is still strong—with the money supply leading price changes by about a year and a half. This relationship is just like Friedman predicted.
Nowadays, the Fed focuses mainly on interest rates in implementing monetary policy, but that has not been a much easier task. Inflation soared from close to zero at the beginning of the Covid pandemic in 2020 to almost 9% in the summer of 2022. During that inflationary burst, the FOMC held the fed funds rate at zero, thereby contributing greatly to the inflationary pressures.
After the Fed began to raise the fed funds rate in March of last year, inflation also started to come down. But it is still exceedingly high, with the CPI currently increasing at about 6.5% on a year-over-year basis. This is more than triple the Fed’s announced target of 2% inflation.
At present, the real or inflation-corrected fed funds rate is still negative as the nominal FFR is lower than the inflation rate. That means the Fed is still pursuing a stimulative policy. The current policy debate within the Fed is whether further FFR increases are needed to reign in inflationary pressures and how long the high rates have to be sustained to control future inflation. The FFR would have to cross and be slightly above the inflation rate to accomplish this objective.
By following this interest-rate strategy, the Fed neglects to look at the money supply measured by M2, which is already sharply reduced and according to the most recent annual growth statistics is actually declining in absolute terms. If we believe Friedman’s monetary-policy dogma, the current monetary policy is already sufficiently restrictive to ultimately defeat inflation—all it will take is a year or a year-and-a-half of patience and no further growth in M2 to accomplish that objective.
Further tightening of monetary policy by steering the FFR higher would also increase the chance of a recession in the foreseeable future. Together with the two quarters of negative growth already experienced in the first half of last year, this possible recession in the middle of this year would be essentially a repeat performance of the early 1980s, when the country also experienced a double dip recession.
The good news is that money-supply growth is now close to zero and is already influencing the inflation rate. Given the typical lag of 12 to 18 months in monetary policy, we can expect that inflation will be defeated towards the end of this year or by the beginning of 2024—just like Friedman would have predicted.
The Fed will have to decide whether to hitch its star and reputation to an almost exclusive focus on current interest rates, which indicate a need for further tightening—or whether to adopt a forward-looking policy that trusts in the future effects of the current money supply data. Such a policy stance would indicate no further need for tightening.
Future interest rates may still increase somewhat, but that would be a result of maintaining the current tight money supply regime and hopefully also a more vibrant economic growth.
This forward-looking policy perspective would also bring us closer to a “Goldilocks” scenario of reduced inflation with continued economic growth.
It is time to remember the lessons about monetary policy and controlling the money supply that we learned from Milton Friedman to assure a more stable and inflation-free economic growth in accordance with the Fed’s congressional mandate.
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