About the author: Jeremy J. Siegel is emeritus professor of Finance of the Wharton School of the University of Pennsylvania and chief economist for WisdomTree Investments.
The Federal Reserve has received kudos since the recent decline in inflation has occurred without a significant increase in unemployment. It’s even been called the “immaculate disinflation.” But the Fed’s lucky streak might be running out. There’s no doubt that the policy followed by the Fed since the pandemic struck in March 2020 has been the primary source of the worst inflation in more than four decades.
For more than 30 years, from the mid-1980s to 2020, the Fed expanded the money supply by about 5.5% per year. That’s measured by M2, which Nobel Prize-winning economist Milton Friedman showed was the prime determinant of inflation. This monetary policy produced an inflation rate of about 2 ½%, with the 3% difference providing liquidity for economic growth.
But after the pandemic started, the Fed produced an explosion of the money supply such as has not been witnessed in the last 150 years. In the four months from March to July 2020, the Fed increased the money supply by 17.5%. The central bank continued to expand money at double-digit rates until March 2022. In those two years, the money supply increased by 41%, almost 30 percentage points above the level it would have reached had the Fed followed the noninflationary pace of the previous three decades.
It was inevitable that this excess liquidity would spill over into inflation.
Certainly, when the pandemic struck, the extra money issuance was necessary to cushion the shock. But even though the economy recovered quickly, the Fed inexplicably kept the money spigot open for two more years while maintaining interest rates at all-time lows. When Fed Chair Jerome Powell was confronted by this prodigious money growth, he asserted that Fed studies showed there was little link between inflation and money supply growth, despite the mountain of historical evidence that supported it.
Some argue that the Fed was helpless considering the more than $7 trillion of government stimulus packages that Congress passed during both the Trump and Biden administrations. But that is not the case. It is one of the prime functions of a central bank to stand in the way of excess government spending. After the initial boost in liquidity, Powell should have told Congress to raise money for the subsequent spending by borrowing from the bond market, a policy that would have raised interest rates far earlier.
How could the government spend $7 trillion without raising taxes while keeping interest rates at record-low levels? The answer is that the Fed printed and simply handed the money to the government. Banana republics where there is no separation between the government and monetary policy have done much the same for years.
In economics, one of the most recognized phrases is, “there is no such thing as a free lunch.” Someone must pay for programs the government passes. When Congress doesn’t have the guts to raise taxes or borrow in the bond market, then printing money, with its subsequent inflation, is inevitable. Inflation is a cruel, nonlegislated tax on those with fixed incomes and savings in bonds and bank deposits.
Powell and the Fed didn’t recognize their mistake until November 2021, and didn’t start raising rates until the following March, well after the flood of liquidity was already accelerating the rate of inflation. Since March 2022, the Fed has slammed on the brakes. The decline in the money supply that year was the largest since the Great Depression of the 1930s, which could have precipitated a recession or worse. Fortunately, the money supply resumed growing this summer as Powell slowed his rate increases.
Powell may yet achieve a slowdown in inflation without a marked increase in unemployment. Yet the damage has been done, as workers and savers have experienced a permanent loss of purchasing power. Powell and his Fed deserve little praise for fixing a problem they caused.
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