After a lifetime studying monetary policy, Milton Friedman famously concluded that inflation was always and everywhere a monetary phenomenon. He also concluded that monetary policy operated with long and variable lags. By this, he meant that the effects of monetary policy actions, like raising interest rates, took some length of time before they fully impacted the economy.
Judging by yesterday’s Federal Reserve decision to leave monetary policy unaltered despite its very much more upbeat view of the U.S. economic outlook and despite the very rapid increase in the U.S. money supply, Fed Chairman Jerome Powell evidently has a decidedly different view of how monetary policy works than had Milton Friedman. Only time will tell whether Mr. Powell is acting wisely or rashly when he chooses to totally ignore Mr. Friedman’s teachings.
From a Friedmanian perspective, among the more striking characteristics of the Powell Fed is its seeming total disregard for the way in which its policies are causing a U.S. money supply explosion. In particular, the Fed seems to be unfazed by the fact that over the past year the Fed’s highly aggressive bond-buying program has contributed to a 30 percent increase in the broad money supply. That is the fastest pace of U.S. money supply increase in the past sixty years by a multiple of around 3.
For Milton Friedman, such a money supply explosion would be a sure sign that inflation was around the corner, especially if the Fed were to continue to finance the U.S. government’s largest budget deficit in peacetime history by printing yet more money. By contrast, for Jerome Powell, who expects inflation to remain well contained, the unusually rapid money supply increase seems to have no real meaning.
Even from a non-Friemanian worldview, the disconnect between the Fed’s upbeat economic forecast and its policy inaction is very difficult to understand.
The Fed has now sharply upgraded its economic forecast in the sense that it now expects that the U.S. economy will grow by 6.5 percent in 2021 and that unemployment will fall to 4.5 percent by yearend. Yet despite that forecast and despite the recent passage of the $1.9 trillion Biden budget stimulus package, the Fed is sticking to its guns that there is no need to change its policy course. Indeed, the Fed is not anticipating raising interest rates until 2024 and it sees no need to dial back its aggressive bond-buying program anytime soon.
Ominously, the bond market does not share the Fed’s sanguine view that inflation will remain well contained despite the record amount of budget and monetary policy stimulus that the economy is now receiving. Indeed, since the start of the year, markets have driven up sharply the all-important 10-year Treasury bond yield from less than 1 percent to around 1.75 percent. At the same time, they have increased their expectation of inflation over the next five years to 2.5 percent, which is meaningfully above the Fed’s 2 percent inflation target.
Another surprising aspect of the Fed’s current policy mindset is its determination to wait until it sees very clear signs of inflation before starting to even think about raising interest rates or tapering its $120 billion a month bond-buying program. Never mind Milton Friedman’s warnings that monetary policy acts with long and variable lags. The Fed in its wisdom seems to think that nowadays inflation can be turned around on a dime and that there is no policy need to anticipate inflation from a likely economic overheating until actual inflation comes knocking at your door.
All of this does not bode well for the U.S. economic and financial market outlook.
The Fed’s seeming indifference to the inflation risks associated with the unprecedentedly large-scale budget and monetary stimulus that the U.S. economy is now receiving appears to be an open invitation to the bond vigilantes to keep selling US government bonds. That in turn risks sending long-term US government bond rates to levels that could very well cause the bursting of the global everything asset and credit market bubble. That bubble, which has been created by years of ultra-easy Fed monetary policy, has been premised on the assumption of an indefinite continuation of ultra-low US government bond rates.
One has to hope that Jerome Powell proves to be right in his apparent view that Milton Friedman’s teachings have no relevance to today’s world. If he does not prove to be right, we should brace ourselves for some rough sledding in the U.S. financial markets in the months immediately ahead and for another leg down in the U.Ss economy next year.