The relationship between money and inflation remains a mystery to many who should understand it – including Federal Reserve Chair Jerome Powell. Late last month he said, “We now better understand how little we know about inflation.” By analyzing the money supply during the global financial crisis that began in 2008 and our current inflation, we can see why the US economy and the Inflation have behaved differently in these two periods. It’s about money, not fiscal policy, supply chains or energy prices.
money dominates. Broad money growth drives nominal spending. In normal times, most money is created by commercial banks. When a bank makes a loan, it credits the borrower’s deposit account. The loan is not from the bank, which is drawing on its reserves from the Fed. Banks can also create money by buying securities, which in turn are credited to the securities account of the issuer or seller of the securities. Provided they can meet all capital, liquidity and leverage requirements, banks create credit out of thin air.
If for any reason the banks’ ability to create money is compromised, the Fed can step in and engage in quantitative easing through large-scale asset purchases. This increases the money supply because the Fed’s purchase of assets from the unbanked public results in a payment going from the Fed to the seller, who deposits the payment with a commercial bank. This is new money. In return, the bank redirects the payment to the Fed, which credits the commercial bank’s reserve account. Thus, QE increases the reserves of both banks and the money supply out of thin air.
During the global financial crisis – which we define as the period in which the Fed conducted QE from 2009 to 2014 – commercial bank balance sheets were severely impacted by non-performing loans to subprime borrowers and losses on securitized loans. Shortage of capital In an environment where capital and other requirements were tightened, most banks stopped lending and money printing in 2008 and only resumed lending in 2012. Fortunately, the Fed stepped in to create money via QE.
The third round of QE ended in 2014. The money supply (M2) increased by just US$3.4 trillion from 2009 to 2014, with US$2.4 trillion coming from Federal Reserve borrowing and US$1 trillion net from bank lending flowed. These changes resulted in a moderate compound annual M2 growth rate of 6.6% over this period. Even with the Fed’s aggressive QE, monetary growth and the resulting compound annual inflation rate of 1.7% (calculated with a one-year lag) have been modest.
The Great Inflation started with the Covid-19 pandemic. Commercial bank balance sheets were in good shape, and in the early stages of the crisis Washington encouraged banks to lend more. The banks were ready and willing to create money, and they did. The Fed stepped in to create more money.
As a result, M2 is up $6.3 trillion since early 2020, with $4.8 trillion coming directly from the Fed and $1.5 trillion net from banks. M2 has grown by an incredible 41% in just 2½ years – a compound annual growth rate of 16.3%. No wonder the US is suffering from its highest compound annual inflation rate in 40 years at 5.7% (calculated with a one-year lag).
“Right now,” Mr. Powell said in a congressional hearing in 2021, “M2 . . . doesn’t really have important implications. It’s something we need to unlearn, I think.” He and other central bankers need to “unlearn” their disdain for monetary analysis before they make another egregious mistake. Because of its excesses, elevated inflation will persist for some time – at least 12 to 24 months.
This inflation is irreversible, but in its panic to hike rates and start quantitative tightening, the Fed allowed M2 growth to ramp down to an anemic annualized growth rate of 0.1 in the three months leading up to June % crashed. When broad money growth falls to near zero, nominal spending falls and a recession begins.
If this tiny money supply growth continues, a recession will begin in late 2022 or early 2023. By raising annual M2 growth to around 6%, the Fed could avoid sending the US into a steep recession that would cause unemployment to rise. But without an M2 on its dashboard, the Fed is flying unnecessarily blind.
Mr. Greenwood is a Fellow at the Johns Hopkins Institute for Applied Economics, Global Health and the Study of Business Enterprise. Mr. Hanke is Professor of Applied Economics at Johns Hopkins University.
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https://www.wsj.com/articles/federal-reserve-ignored-the-money-supply-and-inflation-recession-coming-11657210800 The Fed Ignored the Money Supply, and a Recession Is Coming