Monetary policy can only do so much: it cannot permanently increase the wealth of a nation. That is the lesson from economic history. In the short run, the Fed can affect real variables like output and employment by expansionary monetary policy, but trying to use monetary stimulus as the primary vehicle to move the economy forward is an invitation for price inflation in the longer run.
In enacting President Biden’s $1.9 trillion relief bill, Congress should not expect a miracle. The risk is that as the Fed buys a larger share of the federal debt, inflation could increase—if there is an excess supply of money. Although policymakers are focused on the near term, it would be irresponsible to assume that most of the impact of the monetary stimulus will show up in real economic growth rather than higher inflation.
The Federal Reserve Act, as amended in 1978, states that the Fed’s primary responsibility is to achieve long-run price stability and maximum employment. To do so the Fed is required to “maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production.”
The Fed’s experiment with targeting the quantity of money (actually the quantity of nonborrowed reserves) was short-lived (1979–1982), as financial innovation and other factors weakened the link between money and prices. In 1993, Fed Chairman Alan Greenspan told Congress that the monetary aggregates were not reliable guides for monetary policy. Ben Bernanke moved to an inflation targeting regime in 2012, and last year Jerome Powell moved to “flexible average inflation targeting.”
Rather than aiming at inflation of 2 percent a year, which already deviates from “price stability” (zero inflation), the FOMC now aims at average inflation of 2 percent. That change in the monetary framework gives the Fed greater discretion to pump up money and credit. Indeed, the M2 money supply has increased more than 25 percent during the last 12 months.
Nevertheless, the steep rise in M2 should be viewed in line with the sharp decline in the velocity of money (which means a rise in the demand for money) as a result of the pandemic and near zero interest rates. Consequently, the demand and supply of money may not be that far out of line, thus reducing (for the moment) inflationary pressures. It is uncertain how rapidly velocity will return to trend after the pandemic.
Moreover, it is important to understand that, under the Fed’s new operating system (the so-called floor system), the Board of Governors can increase the interest on excess reserves (IOER) to neutralize the inflationary impact of QE. That means growth in the Fed’s balance sheet mostly results in corresponding growth in bank’s free reserves, with no corresponding growth in broader money measures.
Yet, with IOER near zero and the economy recovering, the Fed may be reluctant to increase the rate it pays on reserves. Consequently, there is a risk that increases in the monetary base could have a larger impact on the monetary aggregates, with implications for future inflation.
Meanwhile, a little more inflation is seen as beneficial in achieving “maximum employment” (which policymakers have never attempted to assign a numerical value, since it is unobservable), and the Fed now believes the Phillips curve is flat. Thus, policymakers believe that monetary stimulus, intended to lower unemployment, is unlikely to generate long-run inflation in excess of the desired 2 percent average.
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