Refocusing the Fed
If you follow the financial press, the conventional wisdom has come to the simple conclusion that the way to fight inflation is raising interest rates. Unfortunately, this is just not true. Yes, raising rates may slow the economy, but that alone won’t fix inflation.
Starting in 2009, for seven years the Federal Reserve held the federal funds rate at zero and yet inflation never accelerated. So, if seven years of zero percent interest rates didn’t cause inflation, why would the last two years do it? Even though everyone talks about interest rates, it is really money supply growth that matters. We follow M2 because that is what Milton Friedman told us to follow. M2 is currency in circulation plus all deposits in all banks (checking, saving, money markets, CDs).
If M2 rises by 10%, we would expect a 10% increase in overall spending. Some of that would be soaked up by real increases in output, but the rest would go to inflation.
From February 2020 – December of 2021, M2 grew at an 18% annual rate. No wonder inflation has climbed to 9%. Raising interest rates, by itself, will not stop this inflation. The way to stop it is by slowing growth in M2 to a low enough rate, for long enough, to allow the economy to absorb the excess money.
That is exactly what happened in the early 1980s when Paul Volcker altered the focus of the Federal Reserve toward money. Prior to Volcker, in the 1970s, the Fed would talk about what level of the federal funds rate it was aiming for, and people started to believe it was the level of rates that mattered. But this was never the case. The Fed consistently held rates lower than a free market (and the level of inflation) suggested it should, because that’s what politicians wanted. In order to do that, it would add more money to the system than real growth required, causing inflation.
In the late 1970’s, Paul Volcker turned this approach on its head. He understood (because of Friedman) that it was money supply growth that mattered. So, he targeted money growth and let interest rates go wherever they may. Some people believe he tightened money too much, and with interest rates spiking well above inflation, close to 20%, this may have been the case.
But it is also why inflation fell. He kept money tight until it was all absorbed and inflation was tamed. It was slower money supply growth, not higher rates that stopped inflation. At the same time, Ronald Reagan cut regulations, tax rates and slowed government spending. This let real economic output accelerate, also helping absorb some of the excess money of the 1970s.
So, if we learned that lesson once, why do we have to learn it again? Part of the answer is that the Fed shifted from a “scarce reserve” policy to an “abundant reserve” policy in 2008. This is what Quantitative Easing (QE) was all about. Under the old “scarce reserve” model the Fed bought bonds from the banking system to increase the money supply and this brought interest rates down. When it sold bonds to banks, the opposite happened. The reason this worked so well is that banks had few, if any, excess reserves. Banks used every dollar created.
Think of it this way. At the end of 2007, the Fed’s balance sheet (basically bank reserves) totaled roughly $850 billion. The M2 money supply (all deposits in all banks) equaled roughly $8 trillion. Banks held roughly $1 in reserves for every $9 in deposits. The “money multiplier” – how many dollars of M2 circulated relative to reserves held at the Fed – was about 9.
But this all changed in 2008. With QE 1, 2 & 3, and then more QE during 2020/21 the Fed increased its balance sheet ten-fold. The Fed’s balance sheet is now roughly $9 trillion, while M2 has grown to $22 trillion. In other words, banks only have about $2.5 of M2 per $1 of reserves, not $9. The Money Multiplier has collapsed, while excess reserves have soared. The Fed has grown tremendously relative to the economy and the banking system. Why? We could speculate on that…after all, some politicians want to nationalize the banking system. But the “how” is equally important.
Back in the 1970s, one of the Fed’s tools was to use reserve requirements to manage money. If the Fed raised reserve requirements it could slow down money creation. Today, with so many excess reserves in the system ($3.3 trillion at last count), the Fed and other banking regulators have layered regulations on banks, pushing required capital ratios from 4%, to 6%, to 10%, or higher. “Reserve requirements” have been replaced by direct regulation on how much capital a bank must hold.
This is why the 2008-2014 QE did not create inflation. The Fed grew its balance sheet, but it also increased capital requirements which kept the banks from multiplying those new reserves.
Brian S. Wesbury, Chief EconomistRobert Stein, Deputy Chief Economist, First Trust
I am happy to provide this perspective from First Trust for a couple of reasons – it makes sense to me and it usually takes a much different point of view from the mainstream media reporting.
I hope you enjoy it. Charles Scott
It’s important that you know there are other takes on what’s happening in our economy and around the world. If a question or two about the content presented in my blog, give me a call at 480-513-1830 or schedule a time to chat via my calendar, Chat With Charles.