The Fed continues to ignore basic economics — and it’s we who will pay the price

A sign of intelligence is learning from one’s mistakes. The Powell Federal Reserve does not display this kind of intelligence.

Last year, it managed to produce multi-decade-high inflation by choosing to ignore Milton Friedman’s fundamental teaching that inflation is always and everywhere a monetary phenomenon. Yet this year, it risks producing an unnecessary recession and inflation below its 2% target by once again choosing to ignore the legendary economist’s lessons.

The essence of Friedman’s teaching is that the money supply is always the basic determinant of inflation. This is the case even though the money supply might operate with a long and variable lag. Too much money in the system will in time almost certainly produce an unwelcome bout of inflation by causing the economy to overheat. Similarly, too little money in the system risks inviting deflation by causing the economy to operate at a level far below its potential.

The truth of the matter is that Powell’s Fed pays practically no attention to the money supply. In fact, it is long since his Fed stopped publishing money-supply data. The money supply is also a conspicuously absent topic in Fed Chair Jerome Powell’s frequent pronouncements on the state of the economy despite its wild gyrations.

This lack of attention to the monetary data has resulted in the Powell Fed allowing wild swings in broad money-supply growth that have never before been experienced in the post-war period.

In the two years following the March 2020 COVID-induced recession, the Fed allowed the broad money supply to expand by a staggering 40%. It did so by keeping its policy rate at its zero-lower bound and increasing the size of its balance sheet by almost $5 trillion through its aggressive purchases of Treasury bonds and mortgage-backed securities.

This year, the Fed is going to the other extreme. In its effort to restore inflation control , it’s allowing the broad money supply to contract. How? By hiking interest rate s at their fastest pace in 40 years and engaging in quantitative tightening at the unprecedented pace of $95 billion a month.

As a result, for the first time since the 2008-2009 Great Recession, we are seeing an actual contraction in the money supply. Yet the Fed keeps insisting it might need to raise interest rates further and shows no sign of even thinking about slowing the pace of its quantitative tightening. That risks causing a further money-supply contraction.

In 2021, when the Fed kept assuring us that the inflation we were seeing was but a transitory phenomenon, the monetarists were warning that the explosion in money-supply growth would take us back to the inflation of the 1970s. In the event, the monetarists were proved correct as inflation surged to more than 9%. Meanwhile, the Fed was left with egg on its face and a loss in its credibility.

Unchastened by its past poor inflation-forecasting performance, the Fed is once again ignoring the monetarists’ warnings. This time around, they’re warning that this money-supply contraction will in time lead to an unnecessary recession and inflation falling to below the Fed’s 2% inflation target. Supporting the monetarists’ claims are the recent signs of economic slowing and the marked deceleration in the pace of inflation.

All of this is not to suggest the Fed should totally abandon its economic model and blindly follow the monetarists’ advice. But the bank should be displaying more humility about its inflation-forecasting ability and not be dismissing these warnings out of hand. Maybe then the Fed will pause to reflect on whether its unusually rapid pace of recent monetary-policy tightening might not be resulting in monetary overkill to reach its inflation objective.

American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.