When the Federal Reserve meets next week, it would do well to recall two of Milton Friedman’s fundamental economic teachings. The first is that monetary policy operates with long and variable lags. The second is that inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.
If the Fed heeds those two lessons at next week’s meeting it might pause raising interest rates after last year’s fastest pace of interest rate increases in the past forty years. By so doing, it might spare us from monetary policy overkill to regain control over inflation and from an unnecessary recession.
Today’s GDP numbers suggest that the Fed’s policy tightening is already working. Stripping out the trade and inventory number from the GDP estimate, we find that inflation-adjusted final sales slowed down to an annualized rate of 0.8 percent in the final quarter of the year. Meanwhile, the personal consumer price deflator, the Fed’s favorite inflation indicator, slowed down to an annualized 3.2 percent in the final quarter of last year. That was the slowest pace of inflation since 2020.
If Milton Friedman is correct in thinking that monetary policy operates with a lag of at least one year, the Fed’s 4 ¼ percentage point hike in interest rates last year could tip us into recession this year. That is because there are already clear signs of economic slowing and the full effects of last year’s interest rate hikes on the economy are yet to be fully felt. It is also because budget policy has now shifted to a very much more restrictive stance and because the large accumulation of housing savings in 2020 and 2021 is now close to depletion.
If Milton Friedman is right in thinking that inflation is always a monetary phenomenon, we could soon see inflation decelerating towards, or to below, the Fed’s 2 percent inflation. That is because the Fed’s newfound monetary policy religion has resulted in an extraordinarily abrupt swing in the money supply from excessive growth to contraction.
In 2020 and 2021, by keeping interest rates too low for too long and by flooding the market with liquidity, the Fed allowed the broad money supply (M2) to increase by a cumulative 40 percent or by its fastest pace in the post-war period. Yet the Fed was blindsided by the surge in inflation to a peak of over 9 percent by June 2022.
Fast forward to today, the Fed has gone to the other extreme. By slamming hard on the monetary policy brakes and by withdrawing $95 billion a month through quantitative tightening, the Fed has allowed the broad money supply to actually contract. This is something that has not occurred in the past sixty years. If Friedman is right, this could presage a very rapid deceleration in inflation.
All of this suggests that the Fed would be well-advised to shift away from its current data-dependent monetary policy approach towards a more forward-looking approach. Instead of reacting to each inflation data point, the Fed might be better served by paying attention to the monetary aggregates and to the lags underlined in Friedman’s monetary policy teachings.
Unfortunately, the Powell Fed shows no signs of doing so as it makes bringing down inflation at all costs its number one priority. That risks setting us up for an unnecessarily hard economic landing.
Author Expertise and Experience: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly 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.