Former Fed Chairman Robert Heller on why we need to stop raising interest rates now

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About the author: Robert Heller He is a former member of the Board of Governors of the Federal Reserve System.

Inflation is the most important issue facing the economy today as per its latest Public opinion poll. Congress gave the Federal Reserve the mandate to maintain “stable prices” along with “maximum employment.” This is the so-called dual mandate, which makes the Federal Reserve responsible for the country’s monetary policy.

Milton Friedman, Nobel laureate and perhaps the most famous monetary economist of all, said in a famous essay: “Inflation is always and everywhere a monetary phenomenon, in the sense that it can only be produced by a rapid increase in the quantity of money more than output.”

One might assume that controlling the amount of money should be a primary task of the Federal Reserve. But this is no longer the case. If you look at the official statements of the Federal Open Market Committee published after every FOMC meeting for the past three years, you’ll be searching in vain for the word “money.” It hasn’t been mentioned once in all these years.

This was not always true when Paul Volcker was in charge of the Federal Reserve in the 1980s, the Fed considered controlling and directing the money supply its most important policy tool. During the 1990s, it was ● speed Of the widely defined money supply, n2, money market funds and other close substitutes for money were introduced. But this trend in the velocity of money has reversed in the years since 2000, and the velocity of money is even lower now than it was in the Volcker years.

While there are certainly some measurement issues that must be taken into account, it would be foolish not to view the money supply at all as a major determinant of inflationary pressures. But that seems to be the Fed’s current policy stance.

Even a casual examination of graphs showing the growth rate of the money supply as measured by M2 and the rate of inflation as reflected in the CPI reveals that the correlation between money and prices remains strong – with money supply changing prices by about a year and a half. This relationship is exactly what Friedman predicted.

At present, the Fed mainly focuses on interest rates in implementing monetary policy, but that has not been a much easier task. The inflation rate rose from near zero at the start of the Covid pandemic in 2020 to nearly 9% in the summer of 2022. During this inflationary outburst, the FOMC kept the federal funds rate at zero, which contributed significantly to inflationary pressures.

After the Fed started raising the federal funds rate in March last year, inflation also began to decline. But it’s still very high, with the CPI currently up about 6.5% year over year. This is more than three times the Fed’s announced target for inflation of 2%.

in this time , fact Or, the inflation-adjusted federal funds rate remains negative as the nominal federal funds rate is less than the inflation rate. This means that the Fed is still pursuing a stimulus policy. The current policy debate within the Fed is whether further FFR increases are needed to control inflationary pressures and how long higher rates should continue to control inflation in the future. The FFR will have to step over and be a little bit above the rate of inflation to achieve this goal.

By following this interest rate strategy, the Fed neglects to look at the money supply measured in M2, which is Already a sharp decline And according to the most recent annual growth stats, that’s actually declining in absolute terms. If we believe Friedman’s monetary policy doctrine, current monetary policy is already constrained enough to eventually defeat inflation – all it takes is a year or a year and a half of patience and no more M2 growth to achieve that goal.

Further tightening of monetary policy by guiding the FFR higher will also increase the chance of a recession in the foreseeable future. Combined with the two quarters of negative growth already experienced in the first half of last year, this potential recession in the middle of this year will essentially be a repeat of the performance in the early 1980s, when the country also experienced a double-dip recession.

The good news is that money supply growth is now close to zero and is already affecting the inflation rate. Given the typical 12-18-month lag in monetary policy, we can expect inflation to be defeated at the end of this year or by the beginning of 2024 – just as Friedman predicted.

The Fed will have to decide whether to tie its star and reputation to an almost exclusive focus on current interest rates, which indicates the need for further tightening — or whether to adopt a forward-looking policy that is confident in the future effects of current money supply data. Such a political stance would indicate that no further tightening is needed.

Future interest rates may continue to rise somewhat, but this will be the result of maintaining the current tight money supply system and hopefully also more vibrant economic growth.

This forward-looking policy perspective would also bring us closer to a “Goldilocks” scenario of lower inflation as economic growth continues.

It is time to remember the lessons of monetary policy and control of the money supply that we learned from Milton Friedman to ensure more stable and inflation-free economic growth as mandated by the Federal Congress.

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