Fed should stay the course until inflation is under 2%

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” The intuition behind this observation is quite simple and goes back, at least, to the 18th century. Suppose the amount of money that all consumers, businesses and other economic actors held were to magically double overnight. It would only be a matter of time before prices started rising, and under certain conditions, the price level also would double. However, how long would it take for people to feel the full effects of this monetary expansion? Weeks? Months? Years? No one knows.

The Federal Reserve expands the money supply by buying assets like U.S. government bonds. When the Fed buys U.S. bonds, the banks gain new reserves, which they loan out, creating more money. Conversely, the Fed contracts the money supply by selling its assets.

In 2008, the Federal Reserve changed how it managed the nation’s money supply. It moved from targeting the growth of the money supply to targeting the effective Federal Funds rates coupled with the Fed paying interest on the reserves banks held at the Fed. The consequences of these policy changes led to a ballooning of bank reserves, from the low tens of billions before 2008 to $3.4 trillion at the latest count. The Fed made the change to forestall a national banking crisis by insuring bank liquidity. However, this massive increase in bank reserves did not initially cause inflation as the banks held on to those reserves.

As a result of distributing COVID-19 relief funds to pretty much everybody, spending rose, eventually triggering inflation. To slow inflation down, the Fed raised the Fed Funds rate, which has reduced inflation but not to the target inflation rate of 2% to which the Fed is committed.

So what should the Fed do? We believe the Fed should stay the course until indicators confirm inflation has cooled to 2%. What will the Fed do? We don’t know, but we can read the tea leaves from our favorite inflation expectation measure: the yield difference between indexed and unindexed five-year government bonds. On Oct. 16, this measure stood at 2.52%. By Dec. 6, it had fallen to 2.05%, which indicated we might be out of the woods.

Unfortunately, it rose back to 2.52% by April 16. Over the last month, it has declined but is at a stubbornly high rate of 2.32%. It seems the last mile is always the hardest.•

__________

Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.