Will the Fed Be Forced to Return to Monetarist Policies?
Since the beginning of 2022, global central banks, led by the U.S. Federal Reserve, have been raising interest rates, at times quite aggressively, in hopes of slowing global demand so it comes into better alignment with supply, thereby easing inflationary pressures. The mechanism has a predictable impact on interest-rate sensitive areas of the economy, like manufacturing, the housing market, and certain areas of consumer finance, making debt-driven spending less appealing. Like clockwork, manufacturing PMI in the United States has been in contractionary territory since October 2022 and the hot pandemic housing market has cooled substantially, with existing home sales declining sharply since February 2022 as rising 30-year mortgage rates reached a peak above 7% last year.
Monetarism is an economic school of thought that emphasizes the role of governments in controlling the amount of money supply. Among its fathers was Milton Friedman, the famed University of Chicago economist who described inflation as “always and everywhere a monetary phenomenon,” meaning that he believed that inflation (and its persistence) is a product of too much money in the economy. After an experiment with monetarism that arguably helped rein in inflation expectations during the Volcker Fed, scrutiny over monetary aggregates gradually became less and less intense in subsequent decades at the Federal Reserve. Culminating with Greenspan, a multi-decade period of low and stable inflation wrung monetarism out of prevailing Federal Reserve monetary policy theory. The decay of institutional memory of the Great Inflation of the 1970s, and growing evidence of a structural disinflation, removed monetarism from the philosophical toolbox of monetary authorities.
Over time, the Fed’s balance sheet has expanded as the existing money supply has risen quite dramatically. The principles of monetarism were unwittingly flipped on their head, as expansion of money supply was seen as playing a role in fending off deflation.
Hawkishness and dovishness by Federal Reserve regional governors is now mostly expressed through differing opinions on what level the Fed Funds Rate should be and how quickly to get it there. Little public debate concerns how to properly handle monetary aggregates and the Fed balance sheet. But can inflation really be brought down sustainably without a return of vigilance regarding money supply?
On the surface, the answer for the last six months has been “yes.” Even with a relatively slow pace of Quantitative Tightening (starting at $45 billion per month last June and accelerating to $90 billion per month in September 2022 as opposed to approximately $2.8 trillion of Quantitative Easing in March to May of 2020 alone according to Statista data), and other pro-liquidity measures that appear to have offset monetary tightening since last October, consumer prices have eased from an annualized peak of 9.1% in June 2022 to recent readings of 6.4% in January. But now comes the real test. The initial disinflationary effect of tighter financial conditions driven by higher central bank interest rates could at some point subside; in fact, evidence appears that the market has spent the last six months frontrunning an easing in conditions. The Fed’s reluctance to aggressively remove excess liquidity may soon lead to stubborn inflation readings, as a propped-up financial economy could spur new credit impulses that reaccelerate flagging economic growth. Higher asset prices also can boost consumer spending as recovering balances in 401(k)s and retirement investment accounts tend to boost consumer confidence.
If monetarist theory is right, and inflation is indeed always and everywhere a monetary phenomenon, that little progress has been made on removing excess liquidity from the financial economy could mean inflation levels will stay above the long-term average as the level of money in the economy is far above the long-term average. And, with so much money in circulation, the U.S. economy may be susceptible to a return of shockingly high inflation should demand for goods reaccelerate globally or another unforeseen shock reverberate through supply chains.
In Axiom’s view, investors should consider hedging the possibility that money supply has an underappreciated effect on long-term inflation by owning inflation beneficiary assets like commodities and continue to closely monitor Federal Reserve monetary actions. If price inflation is the product of too much money chasing too few goods, with the benefit of hindsight, investors may one day realize that roughly $5 trillion of additional money added to the financial economy through the Fed’s balance sheet as well as nearly $10 trillion of public debt added since 2019 (figures according to Bloomberg data) was too much money for any amount of goods that could possibly be produced anytime soon.
