it's the money supply stupid Why Money Supply is the Key to Tackling Inflation

Report by: Ben Jones Published: 27th October 2022

Key points:

Constraining growth in money supply is the key to tackling inflation
Money growth can be restrained at rates lower than prevailing inflation. In other words, tackling inflation does not require rates to be above CPI
1920, 1942, 1947 and 1951 are all examples where inflation was resolved without short term rates exceeding CPI
Fiscal restraint helps bring down the level of interest rate required to restrict growth of broad money

A recurring theme is that the Fed Funds (FF) rate must exceed the level of inflation to bring it down. This is often accompanied by a chart (shown below) that points back to the 1970s and notes that every peak in CPI was met by a higher peak in the FF rate. However, going back a little further in history shows that this isn’t always the case and that inflation can be brought down while rates remain relatively low. The salient point discussed in the article is that it’s not the absolute level of rates that matter, it’s the level of rates required to restrict growth in money supply that matter.

FF rate vs CPI in the 1970s

Source: FRED

It’s worth noting that even in 1979, Volcker made the restriction of credit growth a key aim of the Fed. Raising rates was simply one tool to achieve that aim. Again, it wasn’t the level of rates that were important, the rates were a tool used to limit growth in money supply.

There are examples from history where the level of rates required to tackle inflation were lower than the level of inflation and we look at some of them below.

Inflation in the 1940s

If we dare go back a little further than the 1970s, we see that inflation in the 1940s was not met with significant rate hikes at all. In fact there were disagreements between the Fed and the Treasury over how to manage inflation that peaked at 20% in 1947. Fed Chair Marriner Eccles wanted to raise rates but the Treasury argued that it could not afford high interest payments on a debt which reached 120% of GDP in 1946. A compromise was reached where the Fed raised short term rates from 0.375% (pegged there since 1942) by 0.25% but the long term treasury yield had to be kept at 2.50%. This is while inflation was nearing 20%… Eccles’s constant petitioning for higher rates lost him favour with the White House and he was replaced as Fed Chairman in 1948.

Notice the difference below in rate responses to inflation in the 1940s vs the 1970s.

Chart source: Ben Jones Investments Data source: St Louis Fed & Bloomberg

You could be forgiven for thinking that holding long term rates at 2.50% with inflation at 20% was a recipe for hyperinflation, but no. There are a number of reasons why the US did not experience hyperinflation and why credibility in the Government and Federal Reserve were maintained despite real rates of -17%. These reasons include the US’s position as the clear global economic and military power at the time, the dollar’s status as reserve currency, the removal of a general price cap in 1946, the dire predicament of all other developed economies post WW2 and their need to borrow dollars to rebuild their war-torn economies. However, there is another factor that was vital in tackling inflation that is often overlooked, and that was the restriction in the growth of money supply.

As Friedman would tell us, inflation is always and everywhere a monetary phenomenon. High growth in money supply coupled with large fiscal stimulus is a breeding ground for inflation, but similarly the opposite can help kill inflation. The chart below shows the money supply flat-lining from 1946 to 1948 and it played a key part of tackling inflation in the late 1940s.

Source: Milton Friedman & Anna Schwartzman: A Monetary History of the United States 1867-1960

But how did the Fed limit growth in money supply and maintain low rates? The Fed used the reserve requirement ratio to restrict bank lending and limit the growth in credit. If the reserve requirement is raised, banks must hold more cash against any loans they make. Under fractional reserve banking, this limits the money multiplier effect. For example, with a 10% reserve requirement ratio, a bank must hold $10 as reserve for every $100 of assets. The remaining $90 are lent to businesses and consumers where they’re deposited at other banks. Those banks then lend $81 of the $90, holding $9 as reserve. This goes on until the $100 of original assets are held against loans of $900, totalling $1000 of money. Raising the reserve requirement to 25% would limit growth of that original $100 to $400. This tool was used with great effect by the Fed in the late 1940s to restrict growth in the money supply and reign in inflation. The reserve requirement was raised from 20% to 25% throughout 1947 and 1948. There was also an increase in the margin requirement on security purchases from 40% in 1945 to 100% by 1946, meaning no money could be borrowed to purchase assets. Both of these measures contributed to the restriction on growth of money supply.

Another important factor was that the Treasury ran a surplus from 1947-1949. This instilled confidence that the government was attempting to restore fiscal balance and it also meant that the Treasury was issuing fewer treasuries (borrowing less). The reduced supply of treasuries would naturally clear the market at lower rates because even relatively weak private demand for treasuries could absorb small treasury issuances without demanding a premium in the interest rate. We know there was enough private demand because despite the Fed’s agreement to maintain a cap of 2.50% on long term yields, they did not need to purchase treasuries to maintain that cap. In effect, this meant no more quantitative easing and the Fed’s balance sheet stopped growing.

Inflation 1918-1920

We can also take a look at inflation from 1918-1920. The similarities with post WW2 and with today is that in all cases debt burdens were very high and monetisation of debt was necessary while trying to maintain confidence in the currency. The Fed held the discount rate at 3.75% throughout the duration of the US’s participation in WW1, but raised it to a high of 7% by 1920 in order to bring down inflation of 20%. Again, the impact of the rate hikes were sufficient to restrict growth in money supply and that allowed inflation to drop. However, like WW2, there were also fiscal commitments made that helped contribute to the drop in prices. The Treasury committed to the gold standard ensuring that all credit was backed by gold. This dissuaded fears of debasement and resulted not only in reducing inflation, but actually driving deflation through 1921.

The chart below shows inflationary periods that have been tamed despite relatively low rates.

Source: Ben Jones Investments (chart) ; NBER (data)

We can see below the impact of raising the discount rate was sufficient to induce a broad drop in money supply, despite the discount rate topping out at 7% in the face of 20% inflation.

Source: Milton Friedman & Anna Schwartzman: A Monetary History of the United States 1867-1960

Inflation Today

So what does all of this mean today? The idea that the Fed must ‘crush’ inflation through extreme monetary policy tightening isn’t correct, it’s a misunderstood idea formed by a superficial view of the action taken by Volcker in 1980. The lesson here is that the FF rate does not need to exceed CPI in order to tame inflation, it just needs to be high enough to restrict credit growth. History shows us that as long as money supply growth is limited, inflation will subside over time.

And we know that the Fed is achieving this goal. From December 2021 through to today, M2 is little changed.

Given the success so far in stabilising M2 growth and the deterioration in economic activity seen in manufacturing, services, the housing market and consumer confidence; I would expect that the Fed doesn’t need to continue raising rates so aggressively. It would make perfect sense for the Fed to pause soon and closely watch the impact on money supply. Next week it’s widely expected that the Fed will hike the FF rate to 4%, a level that all Fed members regard as restrictive. Should M2 remain stable, there would be no need for the Fed to continue the hiking cycle (although this doesn’t mean they should immediately begin to ease). However, should money supply begin to grow as inflation remains above target, then more tightening is going to be required.

Ideal policy is for the Fed to tighten the minimum possible while restricting the growth in money supply. This would allow inflation to subside over time while minimising the risk of a deep recession. Fiscal discipline would help lower the natural rate but it looks unlikely that either political party in the US is going to commit to that any time soon and they will continue to leave the Fed doing the heavy lifting.

Given my view that the correct policy would be for the Fed to pause soon, now would be a favourable time to buy treasuries, short the dollar, and go long gold. I’m less bullish on equities given an expected earnings recession driven by the tightening cycle. Of course there remains a risk that further tightening might be required after a pause but that would be an opportunity to buy more risk assets.