Many of the responses to the editors’ and my assessment that monetary policy remains too loose are based on the notion that inflation would not be a problem if fuel prices were not elevated by the war in Iran. Because current inflation stems only from a temporary supply shock, the argument goes, there is no need to tighten the money supply.
If only that were the case. Alas, although the energy shock has certainly contributed to monthly inflation figures, it is not the main culprit. We know this because inflation has been above target — hovering between 2.5 and 4 percent — for the past three years. In the months before the war began, it was still above target, at around 2.5 percent. Even right now, core inflation — which excludes energy and food prices — is above target at 2.6 percent. The Fed’s preferred inflation gauge, which also excludes energy and food, is even higher above target at 3.3 percent. By Kevin Warsh’s own standard, any inflation figure above 2 percent — not any number that begins with a 2 — is unacceptable.
High energy costs are a problem, but they are evidently not the problem. Underlying inflation is still too high because too much money is being created. That is because credit creation (the source of new deposits) is too great, and credit is too plentiful because it is too cheap. The only way to rectify the situation is by making credit costlier, meaning higher interest rates.
This is how the Federal Reserve works. It is how the Fed tamed persistent inflation in the 1980s, and it is how the Fed must tame persistent inflation today. No one likes higher interest rates, but they are all the central bank has to restore price stability in an ample-reserves system.
Yes, inflation has eased dramatically from its peak in 2021 and 2022 — which was accomplished with higher interest rates. Great work. But the job of taming monetary inflation isn’t finished, and it never was. The Fed simply gave up trying a mile out from the finish line, and then started running backward.