December 3, 2023
An old friend of mine called and asked why was the Fed targeting interest rates in order to fight inflation. She wanted a one minute explanation on the relationship between interest rates and the general level of prices. Obviously, the answer took longer than a minute but the root of her question was more insightful than even she realized. Ironically, the night before I was at the annual director holiday dinner hosted by the Nashville branch of the Atlanta Fed. The speaker was an economist at the Atlanta Fed who talked about the Fed’s strategy for combatting inflation and the prospects going forward. What was revealing was that in the entire discussion, he focused on interest rates, employment and real economic growth. I kept quiet because there was no reason for me to comment on his being completely wrong.
Milton Friedman once said that inflation was always a monetary phenomena produced by increases in the money supply that are faster than growth in output. That means that inflation is always caused by governments producing too much money. Yet our central banker did not mention the explosive growth in money produced by the incredible increases in government spending and the enabling of the Fed. That is, the government caused the mess we are in and then attempts to straighten that same mess out. I told my friend that the Fed by financing irresponsible fiscal policy had driven up the money supply driving down interest rates and then tried to hold them near zero. Monetary economics says that that action would then eventually lead to higher inflation. And it did. When the inflation occurred, the Fed’s reaction would then be to decrease the rate of growth in the money supply, driving interest rates up. The key is what happens to the money supply.
But central bankers do not even talk about the money supply and its control, mainly because central bankers seldom understand monetary economics. If they did, they would seek to control the rate of growth in the money supply rather than focusing on interest rates. In monetary economics there is the monetary rule that says that you can have economic growth without inflation if the rate of increase in the money supply is set to the long term growth rate of the economy. Central bankers reject the monetary rule knowing that if they accepted it, they would be out of a job. Central bankers feel obligated to fiddle with the economy. It gives them a sense of importance. However, this discretionary monetary policy is inherently disruptive to the economy, creating busts and booms and periods of inflation and deflation.
Central bankers also craft regulations and oversee financial institutions and most are qualified to do that. The problem with central bankers is that few of them are qualified to do the most important part of their job – control the money supply. Many are lawyers. On the current Fed board there is only one governor trained in monetary economics. The rest are either lawyers or economists with interests other than monetary theory. The chairman is a lawyer. Therefore, it is not surprising that Fed policy is a mish mash of confusing actions and incoherent policy. Interesting that when the one person who was a serious student of monetary economics was nominated to the Board, the Senate rejected the nomination. Imagine if the Supreme Court only had one justice who was a constitutional lawyer. Well that is the current (and most previous) situation at the Federal Reserve and at central banks around the world.
haroldblackphd.com 