The rapid growth of the money supply is a source of rising inflation
Highest inflation in four decades attracts considerable media attention, but limited explanation as to why inflation has accelerated. We last experienced comparable inflation in January 1982, when the rate of inflation was actually falling. This commentary examines the conditions that led to the sudden rise, but first it is instructive to recall the relevant history.
In the early 1980s, the initial source of disinflation was aggressive interest rate hikes by the Volker Fed. While effective in mitigating rising inflation, rate hikes have caused a recession, which the Fed intends to avoid this time around. Today, the Fed is raising interest rates again to quell inflation. Say what you want about the effectiveness of monetary policy, but rest assured that raising interest rates will thwart inflation. Nevertheless, rate hikes aimed at reducing inflation usually precede an economic slowdown and the accompanying rise in unemployment. Given that the Bureau of Economic Analysis reported negative real growth for the first quarter of 2022, a recession may have begun or is approaching.
Inflation in the late 1970s and early 1980s was associated with rising oil prices. Readers may recall the Iranian Revolution which deposed the Shah in favor of Ayatollah Khomeini. While most remember the ensuing hostage-taking, the economic consequence of the revolution was a reduction in Iranian oil production, which reduced the world’s oil supply and caused oil prices to rise. .
Unsurprisingly, rising prices motivated hoarding, which exacerbated price increases. This political event represents a supply shock with global implications. Coincidentally, geopolitical realities are once again disrupting global oil markets. The Russian invasion of Ukraine and subsequent embargo on Russian energy, including oil, reduced the world’s oil supply and drove up oil prices. While sharing an oil supply shock, the cause of the current rise in inflation is closer to home.
Economics is an inexact science. Economists can anticipate economic events, but predictions lack precision as to timing and magnitude. For example, the Soviet Union was doomed, but the prediction proved elusive. Similarly, monetary policy is inaccurate, in part because policymakers face uncertainty, hence the cautious approach of Fed policymakers.
In November 2008, the Fed cut interest rates to 0.3% as part of the Great Recession stimulus effort. The effective federal funds rate targeted by the Fed would remain below 1% until May 2017. The target rate would not exceed 2.5% thereafter. In response to the COVID recession, the Fed cut interest rates below 0.1%. Even today, after an initial half-point rise that rocked stock and bond indices around the world, the effective rate remains below 1%. To lower the target interest rate, the Fed buys assets, usually bonds issued by the US Treasury to fund annual deficits and roll over, that is, refinance in perpetuity, federal debt. In exchange for the bonds, the Fed injects money into the banking system.
How much money has the Fed pumped into the US banking system? In February 2020, the Fed’s balance sheet reflected $4.2 trillion in assets. As of June 1, 2020, assets have ballooned to $7.2 trillion. As of March 21, 2020, the Fed’s balance sheet included assets of nearly $9 trillion. To put it into perspective, consider that immediately before the 2008 financial crisis, assets totaled only $900 billion. In a relatively short period, 12-14 years, the balance sheet has multiplied by 10. In contrast, real GDP has increased by just over 20% since 2008. The money supply has increased more than 40 times faster than economic output. Of course, the current inflation rate is not approaching the 4,000% that this data implies, but the inflation rate suddenly increased and persisted. Having consistently increased the money supply in response to recessions and a financial crisis, the Fed is now challenged to orchestrate anti-inflationary policy, higher interest rates, without causing a recession as seen. in the early 1980s.
Perhaps the current geopolitical conditions and supply chain difficulties associated with the response to the COVID pandemic suggest a potential solution. A commitment to neoliberalism helped drive prices down for decades, as relatively expensive domestic labor was replaced by relatively cheaper foreign labor as production moved overseas. overseas and that the machines were deployed domestically wherever conditions permitted. Recent experience reveals vulnerabilities associated with a global economy driven by comparative cost advantages. The policy to encourage investment in domestic production addresses the vulnerabilities associated with overspecialization while fostering the domestic economic growth needed to offset growth in the money supply. A consequence of increased domestic production will be downward pressure on the trade deficit as domestic production replaces imports.
Over the past few decades, the steady trade deficit has sustained foreign demand for US debt as a way to recycle dollars used to buy foreign goods. A consequence of foreign demand has been lower interest rates on US Treasuries. Able to borrow at extremely low interest rates, it is not surprising that the federal government borrows without hesitation to finance the expansion of spending. Politicians might call spending an investment, but if the return does not exceed the rate of interest, the investment is nothing more than an expense. Some public expenditures are productive, while others are not. Unproductive spending is inflationary.
Critics may argue that domestic production is too expensive to compete with foreign production. While partly true, we must also recognize that technological innovation continues to advance and most production processes are less labor intensive than half a century ago. Policy (i.e. tax incentives) to encourage investment in domestic production will induce firms to identify industries and products suitable for domestic production. The government does not need to identify opportunities. It simply needs to provide incentives for for-profit companies to act in their own interests.
In summary, the rapid growth in money supply without growth in output is the explanation for the sudden increase in inflation. The solution is not simply higher interest rates and acceptance of a recession. The solution is a strategic combination of rate hikes and tax incentives to encourage domestic production.
Higher interest rates will reduce investment in projects with lower expected rates of return, but will not hinder investment in highly profitable projects associated with the relocation of production. The resurgence of domestic production will lessen the need for the Fed to sell assets (bonds) to reduce the money supply and offset monetary growth. Punishing rates and recession is the only option. A soft landing with long-term benefits is also a possibility.
McClough is an associate professor of economics at Ohio Northern University.