If you follow the financial press, the conventional wisdom has come to the simple conclusion that the way to fight inflation is to raise interest rates. Unfortunately, that is simply not true. Yes, raising rates can slow the economy, but that alone won’t solve inflation.
Beginning in 2009, for seven years the Federal Reserve kept the federal funds rate at zero and yet inflation never accelerated. So if seven years of 0% interest rates didn’t cause inflation, why would the last two years? Even though everyone is talking about interest rates, it is really the growth of the money supply that matters. We track M2 – currency in circulation plus all deposits at all banks (checking, savings, money markets, CDs) – because that’s what Milton Friedman told us to track.
If M2 increases by 10%, one would expect a 10% increase in overall spending. Some of it would be absorbed by real increases in production, but the rest would go to inflation.
From February 2020 to December 2021, M2 increased at an annual rate of 18%. No wonder inflation soared to 9%. Raising interest rates alone will not stop this inflation. The way to stop it is to slow M2 growth to a low enough rate, for long enough, to allow the economy to absorb the excess money.
This is exactly what happened in the early 1980s when Paul Volcker changed the Federal Reserve‘s focus on silver. Before Volcker, in the 1970s, the Fed talked about the level of the fed funds rate it was aiming for, and people started to believe that it was the level of the rates that mattered. But that has never been the case. The Fed has always kept rates below what a free market (and the level of inflation) would suggest, because that’s what politicians wanted. To do this, it would add more money to the system than the real growth needed, causing inflation.
At the end of the 1970s, Paul Volcker upset this approach. He understood (because of Friedman) that it was money supply growth that mattered. So he targeted monetary growth and let interest rates go where they could. Some people think he tightened money too much, and with interest rates well outpacing inflation, nearly 20%, that may have been the case.
But that’s also why inflation has come down. He kept money tight until it was fully absorbed and inflation was brought under control. It was slower money supply growth, not higher rates, that brought inflation to a halt. At the same time, Ronald Reagan cut regulations, tax rates and slowed government spending. This allowed real economic output to accelerate, also helping to absorb some of the monetary surplus of the 1970s.
So if we learned this lesson once, why do we have to learn it again? Part of the answer is that the Fed moved from a policy of “scarce reserves” to a policy of “abundant reserves” in 2008. This is what quantitative easing (QE) was all about. Under the old “scarce reserves” model, the Fed bought bonds from the banking system to increase the money supply, which drove interest rates down. When it sold bonds to the banks, the reverse happened. The reason it worked so well is that the banks had little or no excess reserves. The banks used every dollar created.
Think of it this way. At the end of 2007, the Fed’s balance sheet (essentially bank reserves) totaled approximately $850 billion. The M2 money supply (all deposits in all banks) was around $8 billion. Banks held about $1 in reserves for $9 in deposits. The “money multiplier” – how many dollars of M2 circulated relative to reserves held at the Fed – was around 9.
But everything changed in 2008. With QE 1, 2 and 3, then more QE in 2020-2021, the Fed increased its balance sheet tenfold. The Fed’s balance sheet is now around $9 trillion while M2 has grown to $22 trillion. In other words, banks only have about $2.5 of M2 for every $1 of reserves, not $9. The “money multiplier” collapsed, while excess reserves soared. The Fed has grown enormously relative to the economy and the banking system. Why? One could speculate on that…after all, some politicians want to nationalize the banking system. But the “how” is just as important.
In the 1970s, one of the Fed’s tools was to use reserve requirements to manage money. If the Fed increased reserve requirements, it could slow money creation. Today, with so many excess reserves in the system ($3.3 trillion at last count), the Fed and other banking regulators have imposed layered regulations on banks, pushing required capital ratios from 4% to 6%, 10% or more. “Required reserves” have been replaced by direct regulations on the amount of capital a bank must hold.
This is why the 2008-2014 QE did not create inflation. The Fed increased its balance sheet, but it also increased its capital requirements, which prevented banks from multiplying these new reserves.
The response to the pandemic has been different. Treasury debt monetized by the Fed created new money to buy bonds. At the same time, the Treasury and Congress used the banks (through PPP loans and direct deposit stimulus checks) to hand out “stimulus” and the Fed relaxed liquidity rules to allow that to happen. produce. M2’s growth has exploded. In fact, it’s up 41% since February 2020.
So how does this reverse? Once the Fed allows more M2 to be created, it cannot destroy it. All these deposits belong to someone – you, me, your employer or the Treasury. The Fed cannot remove them – they are private property.
There are only three ways to limit money supply growth under the “abundant reserve” model. First, by paying banks interest on their reserves at a rate high enough to prevent them from lending. But this approach means that at a rate of 3.5%, the Fed will pay private banks about $120 billion a year. This may or may not prevent them from lending, but it certainly won’t make politicians like Elizabeth Warren very happy.
Second, the Fed can increase capital requirements, as it already does. Last week, JP Morgan was forced to raise its Tier 1 capital ratio to 12.5% from 11.2%. Jamie Dimon, CEO of JP Morgan, said the rules were “capricious” and “arbitrary”. He is right. They have nothing to do with the banks themselves and have everything to do with slowing the growth of the money supply. At some point, however, it gets ridiculous. The banks are better capitalized and have more liquidity than they probably ever had.
The third way has little to do with the Fed. If the Treasury runs a surplus, as it did in April, it could reduce its debt and allow the Fed to let the bonds mature. But that is unlikely to last. The United States has what appears to be a permanent budget deficit and this is unlikely to change under current leadership.
We’re not saying that rising interest rates won’t cause a recession. What we are saying is that no country in the world has ever had massive inflation problems under the new “abundant reserve” policy model. We are in uncharted territory. Raising rates alone is an unproven tool to slow or halt M2 growth.
Some people say that the velocity of money decreases so we don’t have to worry about M2 so much. A slower speed will help bring inflation down and keep it there. A slower speed means that each dollar stimulates economic activity less than before. But it’s a characteristic of the abundant reserve model, not a Thumbtack. As the Fed expands its balance sheet, so do banks’ balance sheets, but that money is not allowed to flow due to ever-increasing capital requirements. That’s why the speed dropped. The speed itself has not changed, the money has changed.
What worries us most is that the Fed will continue to expand its balance sheet and the power of its government by regulating banks to the point where capital requirements will reach ridiculously high levels.
And that brings us back to Paul Volcker and Ronald Reagan. By slowing the growth of money, Volcker pulled the Fed out of juice activity in the economy. By cutting tax rates and reducing regulations, Reagan revived the private sector. This ended stagflation and led to a boom in the economy.
How do we end the current trajectory and solve our problems again? Our response would be to massively reduce the size of the Fed’s balance sheet. It’s way too big, and it regulates the banks in an extraordinary and unprecedented way. And even though we look like a broken record, reduce the size and scope of the federal government too!
Bringing these two policies together, just as the United States did in the early 1980s, will end the stagflation we have not seen since the 1970s.
Brian Wesbury is Chief Economist and Robert Stein is Deputy Chief Economist at First Trust