Refocusing the Fed

If you follow the financial press, the conventional wisdom has come to the simple conclusion that the way to fight inflation is raising interest rates. Unfortunately, this is just not true. Yes, raising rates may slow the economy, but that alone won’t fix inflation.

Starting in 2009, for seven years the Federal Reserve held the federal funds rate at zero and yet inflation never accelerated. So, if seven years of zero percent interest rates didn’t cause inflation, why would the last two years do it? Even though everyone talks about interest rates, it is really money supply growth that matters. We follow M2 because that is what Milton Friedman told us to follow. M2 is currency in circulation plus all deposits in all banks (checking, saving, money markets, CDs).

If M2 rises by 10%, we would expect a 10% increase in overall spending. Some of that would be soaked up by real increases in output, but the rest would go to inflation.

From February 2020 – December of 2021, M2 grew at an 18% annual rate. No wonder inflation has climbed to 9%. Raising interest rates, by itself, will not stop this inflation. The way to stop it is by slowing growth in M2 to a low enough rate, for long enough, to allow the economy to absorb the excess money.