About the Author: Robert Heller is a former member of the Board of Governors of the Federal Reserve.
As Milton Freedman said in 1970, “Inflation is always and everywhere a monetary phenomenon”. Little has changed since then.
For most of the 1970s, Arthur Burns served as chairman of the Federal Reserve Board. Inflation was rampant, just like now. Consumer price inflation averaged nearly 7% during his tenure. As Friedman correctly diagnosed, this rapid inflation was primarily caused by increases in the money supply of more than 12% during the years 1971-72 and 1976-77. Instead, Burns attributed the price increases primarily to wage pressures, monopoly power, and the oil shock of the early 1970s.
Sound familiar? Inflation is skyrocketing again, and the Fed is blaming supply constraints caused by the pandemic while neglecting to see increased money supply as the primary cause. It’s always easier to blame external factors than something you control and are responsible for.
I had the honor of serving under Chairman Paul Volcker on the Federal Reserve Board beginning in 1986 as he attempted to control inflation. President Jimmy Carter appointed Volcker in August 1979 with a mandate to reduce the rate of inflation to double digits. President Ronald Reagan confirmed this goal after taking office. Determinedly, Volcker raised the federal funds rate to 20% in June 1981 and reduced money supply growth. Not one, but two consecutive recessions resulted.
The situation in Washington was tense as monetary policy medicine took its course. But Volcker and the board prevailed and reduced the annual money supply growth rate from over 12.6% in 1979 to a much more reasonable 5.3% when he left the Fed in August 1987. Alan Greenspan continued anti-inflationary policies. By the time I left the board in 1989, consumer price increases had moderated to just 4.6%.
The Fed was well on its way to defeating inflation and keeping it under control for the rest of the century. The decline in interest rates that accompanied the drop in inflation was a welcome side effect. These low rates have sustained decades of growth and prosperity.
Fast forward to 2020. In response to the deepest recession in US history, the government instituted unprecedented fiscal stimulus that sharply increased the federal deficit. The Federal Reserve supported these fiscal measures by buying up much of the newly issued debt. As a result, the debt-to-gross domestic product ratio hit a record high of 136%, while M2 money supply increased from $15 trillion in January 2020 to $21 trillion in November 2021.
Largely unrelated to the pandemic, but happening at the same time, the Federal Reserve has implemented a significant change in its operating procedures and long-term strategy. After much deliberation, the Fed revised its “Statement on Long-Term Objectives and Monetary Policy Strategy” in August 2020. In it, the Fed essentially threw out the Congressional mandate for “price stability” or zero inflation overboard and reaffirmed its 2% target for the personal consumption expenditure price index. He added the explicit condition that periods of inflation below 2% should be offset by periods of price increases above 2%. Surprisingly, the words “money” or “money supply” are nowhere to be found in this statement on monetary policy strategy.
This change in strategy opened the door to an excessively expansionary monetary policy after a decade of rather moderate inflation. When the pandemic hit, the Fed engaged in massive quantitative easing by buying Treasuries and mortgage-backed securities, resulting in 25% money growth. These actions were accompanied by direct Fed lending to the public under a dozen Section 13(3) facilities.
Just as Friedman predicted, prices reacted with a lag. By the end of 2021, producer prices were soaring at a rate of nearly 10% and consumer prices were up more than 7% year-on-year.
At the start of 2022, inflation is once again running at full speed. However, the Fed is still pursuing a very accommodative monetary policy by buying billions of Treasuries and mortgage-backed securities every month. What sense does it make to buy these instruments when real estate prices are exploding at an annual rate of nearly 20%? Moreover, the Fed is still keeping its foot on the accelerator pedal by keeping the fed funds rate at virtually zero. The Fed continues to provide more fuel for already soaring inflation.
Even more disconcerting may be the fact that for the past two years the Fed has not even once mentioned the word “money” in its official press releases at the end of every Federal Open Market Committee meeting. One has to wonder how an institution charged with monitoring and implementing monetary policy can be so negligent and dismissive of the key asset – money – over which it exercises total control and which is central to the implementation of monetary policy. How long does it take to change an irrational policy that is clearly inconsistent with Congress’ mandate for price stability?
Much like Arthur Burns, current Fed leadership ignores the sharp increase in the money supply over the past two years and instead blames external factors. As a result, inflation is on the rise again. The story repeats itself.
Milton Friedman will turn in his grave.
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