If the past is any guide, when the Federal Reserve meets next week, of one thing we can be sure. The Fed will continue to adhere to a strictly data-dependent monetary policy. It will also continue to ignore the unusually large swings in money supply growth over the past few years. By doing so, the Fed will be choosing to ignore two fundamental teachings of Milton Friedman.
The first of those teachings was that monetary policy operates with long and variable lags. By this, Friedman meant that the full effects of monetary policy generally occurred only after twelve to eighteen months had elapsed. The second teaching was that inflation is always and everywhere a monetary phenomenon. By this, Friedman meant that high inflation could not be sustained without the money supply increasing at a rapid rate. He also meant that prolonged deflationary periods, like the 1930s, were generally associated with a money supply contraction.
One reason the Fed should be paying much more attention to monetary policy’s lagged effects on the economy than it has been doing is the unusual rapidity with which it has raised interest rates and reduced the size of its balance sheet. Over the past eighteen months, the Fed has raised interest rates by 5.25 percentage points. It has also drained more than $1 trillion in market liquidity through reducing the size of its balance sheet at an unprecedentedly rapid pace. Based on past experience, one would think that this monetary policy tightening has yet to work its way through the economy fully. This likely means that the economic slowing that we are already experiencing will gather pace next year.
Another reason to be concerned about monetary policy’s lagged effects is the delayed damage that high-interest rates can inflict on the financial system in general and the regional banks in particular. This would seem to be especially the case at a time when the commercial real estate bubble is ready to burst and when the regional banks are heavily exposed to commercial real estate lending. A clear and present danger is that renewed regional bank troubles could cause credit conditions to tighten much more than they have already done.
In normal circumstances, it is a good idea for the Fed to monitor money supply developments closely. It is a particularly good idea when there have been as wild swings in the money supply as we have recently had.
By ignoring the staggering 40 percent cumulative increase in the broad money supply that occurred between the beginning of 2020 and the end of 2021, the Fed was caught flatfooted by the inflation surge to a multi-decade high of 9 percent by June 2022. The Fed now risks erring in the opposite direction by ignoring the contraction in the broad money supply, resulting from its slamming hard on the monetary policy brakes to regain inflation control.
Not since the Fed began publishing broad money supply data in 1959 have we seen a monetary contraction of the scale we have today. Indeed, over the past year, the broad money supply has contracted by almost 4 percent. At the very least, that contraction should alert the Fed to the possibility that in its zeal to regain inflation control, the Fed has engaged in monetary policy overkill that will produce a hard economic landing.
All of this makes it likely that the Fed will wait too long before making the U-turn needed to avoid a hard economic landing. It also makes it likely that when we do get a hard landing next year, the Jerome Powell Fed will once again drastically slash interest rates and flood the markets with liquidity through another round of quantitative easing to support an ailing economy.
About the Author
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.