Milton Friedman, the renowned expert on the Great Economic Depression and the 1970’s inflationary period, concluded that inflation was always and everywhere a monetary phenomenon. By this Friedman meant that if the Federal Reserve printed an excessive amount of money, in time the economy would overheat and we would have inflation. It would do so as too much money chased too few goods. Similarly, if the Fed caused the money supply to contract, in time we would have a recession and declining price pressure. This is what occurred in the 1930s when the banks were allowed to fail and the money supply was allowed to contract.
The Fed’s sharp swing over the past eighteen months from excessive monetary policy ease to the fastest pace of monetary policy tightening in the past forty years is now providing us with a controlled experiment as to the validity of Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. Underlining the degree of this swing is the fact that we have moved from a two-year period after the Covid recession when the broad money supply increased by a record 40 percent to one when over the past year the broad money supply is now actually contracting as a result of the Fed’s tightening.
Friedman’s view that too much money chasing too few goods causes inflation would seem to have been confirmed by last year’s inflationary surge. At a time when the Fed clung to the belief that inflation was but a transitory phenomenon caused by Covid-related supply side disruptions, and when the Fed kept interest rates at their zero lower-bound, the ballooning of the monetary aggregates was warning of a very different story. In the event, to the Fed’s surprise and as the monetarists predicted, inflation surged to a multi-decade high of 9.1 percent by June 2022.
Surprisingly, despite the Fed’s singular failure to anticipate the worst inflationary outburst in over forty years, the Fed seems to continue to pay no attention to the behavior of the monetary aggregates. No mention of these aggregates is made either in the Fed’s policy statements or in Chairman Powell’s press conferences after the Fed’s policy meetings. Instead, the Fed continues to follow a data dependent policy of raising interest rates on the basis of the latest employment and inflation data. It also continues to rely in its forecasts on a strictly Keynesian economic model that pays little attention to the monetary aggregates. That has induced it to raise interest rates by 500 basis points and to reduce the size of its balance sheet by $95 billion a month through not rolling over its large bond portfolio when these bonds mature.
In Friedman’s view, monetary policy operates with long and variable lags of anywhere between twelve and eighteen months. This makes it too early to deliver a verdict as to whether his view is also correct that the contraction in the monetary aggregates generally leads to recession and lower price pressures. To be sure, headline inflation has now already been more than halved from its peak of 9.1 percent last June to its present level of 4 percent. However, we will only know for sure by the end of the year if he and his monetarist followers were correct in predicting sharply lower inflation on the basis of negative monetary growth. By then eighteen months will have elapsed between the time that the Fed’s recent bout of monetary policy tightening had got fully underway.
While it might be too early to deliver a definite verdict on Friedman’s view, a number of indications suggest that his view could be correct. Since its peak in the middle of last year, inflation has halved and consumer confidence has declined markedly. At the same time, the Fed’s sharp increase in interest rates and large withdrawal of market liquidity is causing strains in the financial system and contributing to a crisis in the real commercial property space.
All of this suggests that the Fed could once again be making a big mistake by ignoring the advance warnings coming from the monetary aggregates. Instead of afflicting us with multi-decade high inflation, by again ignoring the monetary policy aggregates in making its interest rate decisions, the Fed could be setting us up for an unnecessarily hard economic landing.
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.
