As recently as September 2021, half of the members of the Federal Open Market Committee expected no change in the federal funds rate throughout 2022, and not a single member expected a rate hike. at least 75 basis points. Financial market participants were also pleased with the outlook for inflation. Based on fed funds futures prices, the probability that the Fed would not raise rates by December 2022 was 49%. Market participants had apparently swallowed the Fed’s propaganda that temporary supply chain problems caused inflation, which was transitory and would not require a change in policy.
The transient world changed in haste. That’s because January’s headline consumer price index inflation figure screamed at 7.5% and February’s screamed even louder, at 7.9%. As a result, more than half of FOMC members now expect rates to rise by at least 75 basis points by the end of 2022, and none believe the rate will remain unchanged. Fed funds futures now forecast an 84% chance that the rate will be above 150 basis points by December.
Why were the FOMC and the market consensus caught off guard? And what can be done to prevent this kind of error from happening again?
Basically, two things need to be corrected: the Fed’s current modus operandi and the widely held but misguided views about how the Fed and the banking system interact to create inflation.
Ask any Fed officials or observers how monetary policy works, and they’ll tell you it’s all about interest rates. Therefore, the laser is focused on the series of rate hikes expected later this year. But the reality is different. When it comes to inflation, what really matters is not so much the level of rates as what they imply for monetary growth. As Milton Friedman noted, “monetary policy is not about interest rates; it is the growth of the quantity of [broad] money.”
The real source of current inflation is the cumulative increase in money supply measured by M2 since February 2020, an incredible 41.2%. In January, the growth rate of M2, even after three months of reduced bond purchases by the Fed, was still 12.6% above its level a year earlier. That’s about double the rate needed to meet the Fed’s 2% inflation target.
Two sets of entities create money in the US economy: commercial banks and the Federal Reserve. In normal times, banks create most of the money by making loans. When banks grant a mortgage, for example, they credit the borrower’s account with new funds and take out a loan at the same time. Both sides of bank balance sheets are growing.
After the 2008 financial crisis and again during much of the pandemic, this mechanism did not work because banks and borrowers were repairing balance sheets (in the first episode) or were risk averse (in the second). , thus stifling the demand for and the supply of credit. The Fed stepped in with large-scale asset purchases from non-banks, creating new deposits – money – held by the public. The Fed has created about 75% of the $6.4 trillion in new money in the system since February 2020.
Now that the pandemic is easing and normality is returning, banks are lending again and the Fed is reducing its asset purchases. Over the past three months, bank lending has increased sharply, implying a sharp increase in credit demand. Thus, a temporary cut might not be enough for the Fed to slow monetary growth.
How should the Fed calibrate fed funds rate hikes? Ideally, the Fed should ensure that it raises rates enough to slow monetary growth gradually and steadily to a growth rate of around 5-6%. This would be consistent with 2% inflation, as was the case between 2010 and 2019. But to achieve that golden growth rate, the Fed must avoid two potential pitfalls.
The Fed may not raise rates enough, prompting banks and their customers to create excess credit. Given rising demand for credit in a strengthening economy with rising inflation expectations, we could end the year with monetary growth still at its current excessive pace. This would mean that the current inflation rate of 7.9% would persist not just this year, but through 2023 and into 2024. To keep inflation under control, the Fed must deal with soaring demand for credit , as did the Bank of Japan. of the second oil shock in 1979-80.
The Fed must also be careful not to err too much in the other direction. If the Fed raises rates to the point that loan demand evaporates, new deposit creation will plummet and money growth will collapse. With that, the Fed will have precipitated a recession like Paul Volcker did in 1980-81.
During the pandemic, the Fed made a colossal mistake by ignoring the growth rate of the money supply and creating a massive amount of excess money. The Fed now needs to slow monetary growth, but not too much to trigger a recession. To do this, the Fed needs to put the money supply on its dashboard. Right now, he’s absent, which means the Fed is flying blind.
Mr. Greenwood is a Fellow of the Johns Hopkins Institute for Applied Economics, Global Health and the Study of Business Enterprise. Mr. Hanke is a professor of applied economics at Johns Hopkins University.
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