I was amazed that at the recent Federal Open Markets Committee (FOMC) meeting of the US Fed, where inflation fighting dominated the agenda, there was no mention made of the fact that US money supply had increased by 50% over the past two years. One twitter commentator even questioned whether silence on this issue at the subsequent Q&A demonstrated unbelievable incompetence on the part of renowned journalists, or an environment where dissent is not allowed.
This article first examines why interest rates alone are unlikely to tame inflation, and then whether money supply may influence inflation.
Increasing interest rates certainly has the effect of reducing demand. Ironically, precisely in the type of high debt environment we have today, the demand reduction effects of raising interest rates may be more dramatic than in a low debt environment, because Governments, corporations, and individuals must spend more on servicing their debt, leaving less for consumption and investment, depriving economies of their oxygen.
But slowing demand is not the same as slowing inflation. That’s what the whole concept of stagflation is about. The Fed might be well on the way to both recession and inflation. As macro strategist Peter Schiff puts it:
“It’s clear that investors are no longer worried about inflation, but are only worried about recession. In contrast, the Fed is only worried about inflation, but is not concerned about recession. Soon investors and the Fed will be on the same page. They’ll be petrified about both.”
The Fed was late to recognize that inflation was here to stay, hence began applying the brakes against a backdrop of already pronounced economic decline and a bear market. This has never happened before in the history of the Fed. Given that consumption, employment, and investment statistics are always reported with a lag, the rapid oxygen deprivation effect of high interest rates in a high debt environment may plunge us into recession before the Fed may take corrective action.
There are also other aspects of inflation that cannot be controlled by interest rates:
Supply side factors
- Energy prices are the main threat at present. There are many factors contributing to this, from the shuttering of nuclear capacity in Germany to the restriction of Russian oil and gas flows to the West. Germany has already declared having reached stage 2 of its three-stage energy emergency program. Many of the higher wholesale energy prices have not even been transmitted to the retail level. I recently heard from a Hungarian energy expert that retail gas prices in Hungary are expected to go up 400-600% over the next year. Clearly, the full effect of energy price increases in nowhere near baked into current inflation rates.
- While wheat prices may have come down 20% from their recent peak, it remains very expensive, and global wheat stocks are at historic lows.
The psychological dimension to inflation.
- There is increasing evidence that people are coming to expect higher inflation, which gets translated into higher salary demands, etc., creating a spiral.
During the 2008 recession, money supply was increased, but most of this additional money supply was sterilized at the level of the banks, avoiding inflation. Ever since Covid-19, helicopter money and increased levels of bank lending have put vastly more money into the hands of individuals and corporations, with inflationary effect.
Modern Monetary Policy (MMP) is a school of thought that says that a central bank may print an infinite amount of its own currency without affecting inflation, so long as this additional money supply is absorbed by central bank bond purchases. Jerome Powell has announced that he intends to reduce the Fed’s balance sheet (e.g., sell bonds) to the tune of over $2 trillion, at a time when there will be a need to finance at least an additional $2 trillion of federal deficit. Who is going to buy all these bonds, carrying large negative yields, if not the Fed?
We are entering into the realm of voodoo economics. Markets have every right to be concerned.