Inflation will not come under control until the Fed balance sheet comes under control.
Inflation will not come under control until the Fed balance sheet comes under control.
I magine you were driving your car and it ran out of gas. Would you call for a new set of tires or a new battery and expect that to get you back on your way?
If you don’t understand why your car is no longer running, you will likely be unable to get it going again. Bizarrely, American policy-makers seem to have no idea why inflation is raging out of control and look for fixes that have nothing to do with the causes of inflation.
So, let’s get back to basics. What is inflation? By definition, a positive inflation rate means that the prices of goods and services are broadly rising as measured in dollars. Flip that upside down, and what positive inflation means, by definition, is that the value of the monetary unit is declining in terms of what it can buy.
If the price of something is declining, what would elementary economics suggest might be the culprit? Supply and demand? The demand for money is related, however imperfectly, to the overall economy, but the supply of money is the sole province of the central bank — in the U.S., that means the Federal Reserve.
What the Federal Reserve has done in the past three years is dramatically increase the supply of money relative to the supplies of everything else in the economy. Simple supply-and-demand considerations would imply that the “price” of money would fall — by a lot. And it did. The money supply is still growing in the U.S., and its “price” continues to fall. The growth in the supply of money is the cause of our current inflation.
If policy-makers are unwilling to see that excessive growth in the money supply is fueling our current inflation, then the policies they implement will be unable to fix the problem.
Raising the Federal Reserve target for the overnight funds rate — the rate at which member banks loan one another overnight reserves — will have no impact whatsoever on inflation. What the Fed will or will not do on interest-rate targets will have zero impact on the rate of inflation surging through the U.S. economy, unless such rate changes lower the growth rate of the money supply, just as a new set of tires will not get a car that has run out of gas going again — unless the new tires, magically, provide gas to the engine.
The money supply is still growing. That’s what quantitative easing is. The Fed prints money and buys debt. That money becomes an addition to the money supply. As the Fed buys more debt, the money supply continues to grow. The Fed is still buying debt. The Fed says its purchases of debt will stop in March, which remains to be seen. But why is the Fed continuing to expand the money supply now in the wake of rising inflation? The reason seems to be that the Fed rejects the proposition that expanding supply lowers a price. That view wouldn’t pass muster in anyone’s Economics 101 class.
As the late Milton Friedman tirelessly pointed out, you can’t have inflation without excessive monetary growth and you can’t have excessive monetary growth without its leading to inflation. There are no historical examples that counter this proposition.
Unless the Fed is willing to face the facts on the causes of inflation, the problem will get worse — and it could get much worse. It’s the Fed balance sheet that is the problem, not the Fed target ranges for overnight lending. Inflation will not come under control until the Fed balance sheet comes under control.
Paul Volcker, likely the greatest Federal Reserve chairman in U.S. history, recognized that the inflation in the late 1970s was the result of excessive monetary growth. Volcker proceeded with a policy to dramatically reduce the growth in the money supply. That policy succeeded in breaking the back of inflation. It took two to three years to accomplish Volcker’s mission, but the mission succeeded. Interest rates and unemployment soared as Volcker cranked down the growth in the money supply. There is always a price to be paid when combating inflation. We paid that price in the early 1980s and we are destined to pay it again, once the real cause of inflation is acknowledged. Until then, expect inflation to continue to wreak havoc on the American economy.