Inflation has critics of the Federal Reserve pointing to an increase in the money supply

The Fed shared this view the last time the United States had a serious inflation problem. In 1979, then-Fed Chairman Paul Volcker capped money supply and drove inflation from a peak of 14.8% to 2.5% three years later, at the cost of two painful recessions. .

But current Fed Chairman Jerome H. Powell has dismissed claims that Fed money printing is fueling the current price spiral, instead pointing to the disruptions associated with the reopening of the economy. Like his most recent predecessors, dating back to Alan Greenspan, Powell argues that financial innovations mean there is no longer a link between the amount of money circulating in the economy and rising prices.

“From now on, we think more of the imbalances between supply and demand in the real economy only than of the monetary aggregates. … It’s been a different economy and a different financial system for a while,” Powell said in December.

Inflation leads to higher prices at the gas station and at the grocery store. Experts explain what causes inflation and how long it could last. (Sarah Hashemi, Hadley Green/The Washington Post)

The persistence of inflation, which is currently running at an annual rate of 7%, has provided arguments for conservative critics of the central bank known as “monetarists” to adhere to the writings of economist Milton Friedman.

Nobel laureate Friedman taught that “inflation is always and everywhere a monetary phenomenon” and said central bankers should prevent the money supply from growing faster than economic output.

Robert Heller, who served under Volcker on the Fed’s Board of Governors in the 1980s, said Powell was wrong in ignoring the lessons of that era.

“Neglecting to pay attention to the money supply is once again driving the Fed into dangerous inflationary territory – just like half a century ago,” he wrote via email.

The broadest measure of the Fed’s money supply, called M2, is over $21.6 trillion today, up from $15.5 trillion in February 2020.

To facilitate credit during the pandemic, the central bank helped boost the money supply by buying nearly $5 trillion in mortgage-backed and government securities. The Treasury Department stepped in by borrowing trillions more to send stimulus checks to most Americans.

But much of this new money has not been spent. Instead, the financial institutions the Fed paid for those bonds deposited more than $2 trillion in their central bank accounts, while U.S. households banked much of their stimulus checks. and now have savings estimated at $2.7 trillion.

This is one of the reasons why the Fed’s money creation does not stimulate inflation, according to many economists. Yes, there is a lot more money stored in various forms. But it’s moving through the economy slower than at almost any time in 65 years.

“Money supply has gone up, but velocity has gone down,” said former Treasury official David Beckworth, now at the Mercatus Center at George Mason University. “They parked it. They don’t spend it.

Before Volcker changed course in the 1980s, the Fed set targets for money supply growth roughly in line with economic activity. If the amount of money available to the public – currency, coins, checking accounts and certificates of deposit – exceeded the target, the Fed would raise interest rates to calm things down.

If the money supply grew too slowly, the Fed could cut rates to stimulate economic growth. But for at least three decades, Fed chiefs have followed prices and the labor market rather than the money supply to determine whether interest rates should be raised or lowered.

After declaring throughout 2021 that inflation would prove “transient”, Powell in recent months has grown more alarmed by rising prices.

Speaking to reporters last month after the Fed’s last policy meeting, he signaled that the central bank would likely raise its key rate as early as March.

At nearly every Capitol Hill appearance over the past year, Powell has been pushed by Republicans about soaring money. During a Senate Banking Committee confirmation hearing in January for two Fed nominees, Sen. John Neely Kennedy (R-La.) complained of “too much money for too few goods.” .

Powell told a House committee in December that the once strong link between money supply and inflation “ended about 40 years ago.” Financial deregulation and innovations such as interest-bearing current accounts and mutual funds mean that traditional measures of money supply no longer provide reliable signals about future price trends.

Determining how much “money” exists at any given time is harder than it looks. Depending on the circumstances, “cash” can mean real dollar bills, travelers checks, money market mutual funds or even treasury bills. Not all of them can be immediately used in a commercial or consumer transaction, which makes it difficult to predict their economic consequences.

“You’ve seen a whole series of innovations in banking that have made it almost impossible for the Fed to do anything,” said Dean Baker, senior economist at the Center for Economic and Policy Research. “It’s an exercise in futility.”

Powell’s position reflects mainstream economic thinking. But a determined monetarist faction insists the Fed should develop new tools to track the amount of money being created.

Steve Hanke, a professor of applied economics at Johns Hopkins University, said the extra funds the Fed has pumped into the economy are causing an inflationary response that will last longer than the central bank expected. Once the pandemic passes, all the funds that consumers and financial institutions are sitting on will start flowing again, driving up prices, he said.

The money supply is growing at an annual rate of 13%, which until the pandemic was the fastest growth since the late 1970s. Even if the Fed moved quickly to cut this increase in half, inflation annual will exceed 6% through 2024, Hanke said.

“He’s like a doctor. If you have a faulty thermometer, your prescription could be very wrong,” Hanke said. “The Fed’s thermometer is faulty.”

William Barnett, an economist at the nonprofit Center for Financial Stability, developed an alternative measure of money supply called the Divisia series while working for the Fed in the Volcker years. Unlike the Fed’s gauge, which simply totals all different types of money, Barnett’s measuring stick gives more weight to those that are more “liquid” or available for immediate use.

Yet even Volcker, who pioneered the use of monetarism at the Fed, eventually abandoned a strict reliance on money supply growth in managing the economy.

In his fight against inflation, Volcker in 1980 raised interest rates to 20%. Public outcry was fierce as mortgages became virtually unaffordable and unemployment rose. Homebuilders mailed two-by-fours to Fed headquarters in Washington in protest.

Two years later, with unemployment approaching 10%, Volcker backtracked. Although money supply growth was above the Fed’s target for most of the year, it agreed to cut interest rates rather than raise them as monetarism demanded.

Several years later, when low interest rates encouraged Americans to shift their money from traditional savings accounts and CDs to mutual funds offering higher yields, the Fed dropped its remaining monetary indicator.

These new investment funds were not counted in the larger measure of the Fed’s money supply known as M2. So even as the economy grew rapidly, the Fed’s money supply gauge – which ignored popular investment funds – signaled a recession.

“The historical relationships between money and income, and between money and the price level have largely broken down, robbing aggregates of much of their usefulness as policy guides,” the president said. of the Fed, Alan Greenspan, to Congress in 1993.

For all but the monetarists, the years following the end of the 2008-2009 recession cemented this verdict.

The broadest measure of the Fed’s money supply grew by about 45% between the start of 2010 and the end of 2015, significantly faster than the growth in economic output. Yet consumer price inflation started this period at 2.6% and ended it at 0.7% – the opposite of what monetarism would have predicted.

Hanke said the problem lies with the Fed’s measures: the Divisia measure shows that the money supply has grown much less over this period than traditional data suggests. But he admits having made few converts at the central bank.

“We speak a different language,” he says.

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