Economic Outlook | Spring 2022
In response to a shutdown of the global economy brought on by the COVID 19 pandemic, the Federal Reserve Bank (Fed) instituted several emergency measures. Some were temporary (credit facilities to ensure access to the debt market) and others have been longer lasting (near zero interest rates and quantitative easing). These emergency measures addressed weak economic growth and low employment at the expense of future inflation. At the time, it made sense. Economic activity stopped, and we needed to kickstart the economy. Now, with unemployment at 3.8%* and the most recent CPI (inflation) number at 7.9%, the Fed believes it is time to deal with inflation.
The late, well respected economist Milton Friedman, famously noted, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. After the Fed increased the money supply (as measured by M2) by 41.2% since February 2020*, the question wasn’t if they’d have to correct course, but when. The answer, apparently, is now!
The supply of money is increased when:
1. Banks make loans
2. The federal government spends money without raising taxes (borrow and spend)
3. The Fed engages in quantitative easing (purchasing bonds with printed money)
We’ve done all three. If Mr. Friedman is correct, how do higher interest rates reduce the quantity of money? It doesn’t. Inflation is caused both by the quantity of money and the rate at which money moves through the economy; known as the money multiplier effect. As rates increase, individuals spend less and save more. Businesses are also less likely to borrow and expand. Dollars that sit in the bank do not cause inflation.
If the Fed is right and higher rates and an end to quantitative easing is the answer to higher inflation, won’t this hurt the economy? The Fed is charged with a dual mandate of price stability and maximum employment. Policies they enact naturally benefit one goal at the expense of the other. In other words, by enacting policies to pursue full employment (lower rates, quantitative easing) you are risking inflation. With unemployment at 3.8% and inflation well above the targeted 2%, its time to tighten. Officials signaled they expect to raise the Federal Funds rate to 2.75% by the end of 2023. This would be the highest rate since 2008.*
Is the labor market strong enough to withstand 7 rate hikes this year? Chairman Powell certainly believes so and stated as much in his zoom press conference on March 16. He’s not the only economist to think so. “Employment is sizzling”, according to Grant Thornton chief economist Diane Swonk.*
Is it enough?
Even with the eleven 25-point rate hikes expected by the Fed over the next two years the federal funds rate would still be below the expected rate of inflation. In other words, real rates would be negative. Historically, inflation doesn’t begin to fall until the nominal rate exceeds the expected inflation rate.*
As the Fed aims to control inflation, without causing a recession, investors will be paying close attention.
1. Barrons, Stagflation is here March 7, 2022
2. Wall Street Journal, The Fed Needs to put its eye on the Money Supply March 11, 2022.
3. Wall Street Journal, Fed lifts rates and signals six more increases March 17, 2022
4. Barrons, The Economy March 7, 2022
5. Wall Street Journal, Jerome Powell, Inflation Fighter? March 17, 2022