The Fed is stumbling back into the stop-and-go policy regime of the 1970s.
A rules-based monetary policy would provide greater stability for consumers and businesses alike.
A fter ten consecutive hikes, the Federal Reserve kept its interest-rate target at 5.25 percent. While this comes as a relief to banks with troubled balance sheets, it means the battle against inflation will take longer to win. Consumer prices are up 4 percent since last year. Excluding volatile food and energy prices, the figure is 5.3 percent.
Judging by interest rates, monetary policy is appropriately tight. But liquidity conditions indicate that things are more dire. The Fed is forced to sort out conflicting signals — and since its “average” inflation target gives no clear path for the dollar’s purchasing power, markets don’t know what to expect. To restore policy predictability, the Fed should embrace a rules-based approach founded on the link between the money supply and total output.
Some of our economic problems are beyond the Fed’s control. Growth is a measly 1.3 percent and labor-force participation, although rising, is significantly below the historical norm. Monetary policy can’t fix these supply-side problems. But central bankers could make things worse if they inadvertently create an economy-wide demand shortfall.
Setting the interest-rate target too high causes needless economic pain, whereas setting the target too low causes an unsustainable boom. It appears the Fed is in the neighborhood of appropriate policy when we factor in the new consumer-price data. Given the Fed’s decision to hold steady, the inflation-adjusted interest rate is now between −0.05 and 1.25 percent. Most economists think the natural rate of interest, which is the rate consistent with maximum sustainable output and employment, is between 0.5 percent and 1 percent. By this measure, we’re close.
But it’s a mistake to reduce monetary policy to interest rates alone. The interest rate is the rental price of capital. This single price doesn’t fully capture whether the Fed is doing its job of maintaining adequate liquidity. We must also look at the money supply. After a huge jump from 2020 to 2022, money growth has significantly slowed. In fact, it’s turned negative. The most recent figures show the money supply shrinking at almost 5 percent per year — a magnitude not seen since the Great Depression. Monetary policy-makers could throw a wrench in the economy’s gears if they aren’t careful.
In recent years, economists have soured on the money supply as an indicator of monetary policy. This is foolish. True, by itself, the money supply only weakly predicts inflation, because increases in the demand to hold money can offset a liquidity surge. However, it’s possible to control for these changes. Whenever the money supply outruns the demand to hold it, dollar depreciation results. Economists need to rediscover this old wisdom.
Joshua Hendrickson, chair of the economics department at the University of Mississippi, developed a forecasting model that predicts the high inflation we observed in 2021 and 2022. “The failure to foresee such an occurrence was due to the lack of money in monetary policy analysis,” he claims. Policy-makers paid too much attention to interest rates, supply-chain issues, and other secondary factors. Ultimately, monetary policy is still about money.
Money matters because it drives total spending, what economists call aggregate demand. In the short run, increased aggregate demand can boost output and employment. But in the long run all we get is inflation. For the last two years, total spending outran the economy’s capacity to produce, driving up prices. This explains why the Fed needed to tighten. But now, with the money supply shrinking, we have to worry about the opposite: a negative economic shock caused by an abrupt spending slowdown. The resulting decline in jobs and income would squeeze American households even tighter than recent inflation.
Worryingly, the Fed is stumbling back into the stop-and-go policy regime of the 1970s. This scatterbrained approach to monetary control did considerable damage to markets. Central bankers were always a step behind the economy: first too slow to react to runaway inflation, then too hesitant to get in front of incipient recessions. The problem was an overreliance on improvisation and a dearth of discipline.
To fix monetary policy, central bankers must stop tinkering with the economy as if it were a machine. A strict policy rule should force the Fed to create a stable and predictable path for the dollar’s purchasing power. That would prevent economy-wide disruptions caused by too much or too little liquidity. It would also help firms and households form reliable expectations about the future, which facilitates long-term contracting. The first law of monetary policy should be the same as the first law of medicine: Do no harm.
Monetary policy is hard even under the best of circumstances. It’s even harder when interest rates and the money supply are giving conflicting signals. Thankfully, we have options besides relying on central bankers’ judgment calls. Central banking done right is more like gardening than engineering. It’s time to put the Fed on a rules-based footing.