Milton Friedman famously said: “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 output.” This is what we are experiencing, and it is due to the Federal Reserve’s policy since 2008 of buying trillions of dollars of Treasury debt to keep interest rates low and at the same time paying banks to keep reserves at the Fed.
In the past, when the federal government ran a deficit and sold bonds, the Federal Reserve monetized the federal debt by purchasing the bonds. This would add to the reserves of banks, and banks would lend these reserves out. These loans resulted in an increase in checking accounts, therefore increasing the money supply and resulting in inflation. Thus, the adage that federal government deficits lead to inflation.
In October 2008, however, the Fed began paying interest on the reserves banks held at the Fed. This was effective in keeping the money supply from increasing as banks kept the reserves on deposit with the Fed. The excess reserves of banks were less than $2 billion in August 2008 and are more than $3.6 trillion now. So, as the federal debt rose from $10 trillion in fiscal year 2008 to more than $30 trillion, instead of the Fed’s purchases of the massive Treasury debt entering the money supply, they remained as reserves of banks.
Recently banks began to lend out some of these reserves, and the money supply measure M2 rose from $15.4 trillion in February 2020 to $21.7 trillion in April 2022, an increase of 29%. Not surprisingly, inflation has now become a problem.
The Fed is using interest rate targeting as a way to deal with inflation — that is, raising interest rates to reduce the demand for goods and services. This is within the standard Keynesian model that holds that inflation is caused by aggregate demand being greater than aggregate supply. Raising interest rates is an attempt to reduce demand as a mechanism for reducing inflation. However, increasing interest rates may encourage banks to lend out more of the excess reserves and thus further increase the money supply, exacerbating inflation. In addition, rising interest rates may reduce the amount of investment in physical capital, thus reducing potential output.
Rather than interest rate targeting, the Fed should follow Friedman’s advice to undertake a rule of growing the money supply at 3% or the growth of real output. This will be exceedingly difficult to do given the policies of the last 14 years that have led to trillions of dollars of excess reserves that are available to enter the money supply. Rather than raising the interest rate, the Fed should slow the increase in the money supply by restoring the reserve requirement that was abandoned in March 2020.
Gary Wolfram is the William Simon professor of economics at Hillsdale College and the author of A Capitalist Manifesto.
