The Fed Wakes Up to Inflation

By SBE Council at 5 May, 2022, 9:20 am

by Raymond J. Keating –

Eventually, economic reality even catches up to the Federal Reserve. And the current reality is that inflation is running red hot. The question remains, however, if at least one part of the Fed’s remedy will actually work.

In the May 4 FOMC statement, the Fed declared that it is “highly attentive to inflation risks.” Well, better late than never, I suppose.

The Fed said that it has “decided to raise the target range for the federal funds rate to 3/4 to 1 percent and anticipates that ongoing increases in the target range will be appropriate.” The May 4 half-point increase is to be followed by similar increases in coming months, according to Fed Chairman Jerome Powell.

More interesting was the Fed’s declaration that “the Committee decided to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities on June 1…” And the Fed actually issued a basic outline as to how it plans to go about reducing its securities holdings “over time in a predictable manner.”

Fed’s Action Plan

The Fed is playing on two fronts here – though they certainly are related.

First, it’s now set on a path of hiking interest rates. When the Fed goes beyond following the market on interest rates, it risks an economic slowdown or recession. But when the dominant thinking is that inflation results from economic and employment growth running too hot, this is the typical policy response. Indeed, this is nothing new in terms of Fed policymaking.

Federal Reserve Bank of St. Louis, FRED

Second, and hopefully more productive, will be the Fed reining in the monetary base (i.e., currency in circulation and bank reserves). This is the part of the money supply that the Fed has direct control over. As noted in the above chart, after an unprecedented (though uneven) expansion since 2008, the monetary base peaked in December 2021, moved down in January and February of this year, but actually inched back up a bit in March (thought still below the December high).

There’s so much that is striking in this chart, namely, that the Fed in late summer 2008 began running monetary policy that amounted to breathtaking break with history. Much of this historic loose money, however, for a variety of reasons, wound up being channeled into bank reserves. Indeed, the monetary base and reserves track closely. But the most recent, pandemic jump into even looser money saw a step-up in the growth of currency in circulation.

Inflation 101

Keep in mind Milton Freidman’s declaration that inflation is always a monetary phenomenon. Also, there’s the classic definition of inflation resulting from too much money chasing too few goods.

One can argue that since the pandemic hit, we are in a period of too much money chasing too few goods, with production being constrained primarily by pandemic problems and a step up in money in circulation, resulting in inflation.

There’s a great deal to ponder, integrate and disentangle in the current period of inflation – from monetary policy to supply-chain problems to a tight labor market to policymaking working against growth in other areas (such as tax, regulatory and trade policies) – but to the extent that the Fed can reduce the monetary base, that will reduce the risks, uncertainties and contribution to inflation that emerge from this astounding period of loose money.

Indeed, that action would be the most productive undertaking in which the Fed could engage.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.