Does The Fed Add Fuel To Inflation?

The American economy is adding close to half a million jobs a month. Unemployment is hovering close to a 20-year low. Meanwhile, inflation is running at an annual rate of 7.5%, a 40-year high. Yet the Fed continues to keep monetary easing policies set in place during the pandemic recession.

That sounds like the central bank is adding fuel to the inflation fire. At least, that’s the reading of the Fed’s recent notes by some Fed observers.

"The notes reveal that the Fed continues to be behind the curve in understanding the basic economics of the impact of its increased money supply on inflation and the stronger stance needed to contain it," says Tomas J. Philipson, economist at the University of Chicago and former White House Council of Economic Advisers chair. "Indeed, the Fed is still today pursuing inflationary policy a year into an inflationary period that basic economics tell us would occur: a massive increase in the money supply causes inflation."

That isn't what Modern Monetary Theory (MMT) tells us. But Philipson thinks MMT is wrong.

"The current inflation is strong evidence that Milton Friedman was right and Modern Monetary Theory (MMT) wrong," he adds.

Udayan Roy, professor of economics at LIU Post, is on the same page as Philipson on MMT. But he thinks Milton Friedman's monetarism is not very dependable, either.

"There really isn't a tight relationship between the growth rates of monetary aggregates -- such as the monetary bases and M2 -- and inflation," he says.

"The Fed has kept interest rates close to zero since the Great Recession of 2008-09," he continues. "And yet, inflation appeared only very recently. Moreover, inflation has been largely below the Fed's 2% target even though the fed funds rate has been close to zero for most of the post-2008 period."

So, what's different this time around?

Supply-side constraints as the economy tries to return to normal after the pandemic recession.

"The recent inflation is very likely related to the reopening problems of the world's economies after the COVID-19 lockdown," adds Roy. "There is no point blaming the Fed for not being psychics. Now that the surprise inflation is apparent, the Fed will tighten."

Paul Kutasovic, professor of economics at the New York Institute of Technology, thinks the Fed is doing a good job with monetary policy already changing course.

"M2 money supply growth peaked in February 2021 [y/y growth] and has slowed sharply since then," he says. "Moreover, it continues to slow."

Meanwhile, he thinks that the current increase in the money supply shouldn't be a problem within the monetarist view of the world.

"That is because of the massive drop in velocity in 2000," Kutasovic continues. "This was the largest drop on record. So, the surge in the money supply offset the drop in velocity. As Philipson should know better than me, the monetarist model assumes that the demand for money is stable and, therefore, the velocity of money is relatively constant. If the velocity of money declines, the Fed must increase the money supply just to offset the decline. There is then no net stimulus."

Simply put, the Fed doesn't add fuel to the inflation fire. But it isn't trying to extinguish the fire either thus far, leaving itself open to criticism from all sides.