Why it’s high time the Federal Reserve stopped raising interest rates
Gary Wolfram
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In its attempt to suppress inflation, the Federal Reserve once again raised short-term interest rates, bringing the federal funds rate to a range of 5.0 to 5.25%. This is the highest the federal funds rate has been since 2007. Since March 2022, the Federal Reserve has increased its interest rate target on the federal funds rate 10 times.
The Federal Reserve’s response to the inflation problem is consistent with Keynesian economic theory. John Maynard Keynes argued that inflation is caused by the total demand for all goods and services (aggregate demand) being larger than the aggregate supply of all goods and services. The solution to inflation, then, is to reduce aggregate demand. The Federal Reserve has the ability to do this by increasing interest rates: At higher interest rates, there will be less investment demand (demand for factories and machinery) and less consumption demand — thus less aggregate demand. The Fed has been hoping to decrease output and increase unemployment in an attempt to reach a “soft landing,” that is, a reduction in economic activity that won’t create a recession.
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Yet, as Nobel Laureate Milton Friedman famously stated, “Inflation is always and everywhere a monetary phenomenon in the sense that it can be produced only by a more rapid increase in the quantity of money than output.” The inflation we’ve experienced isn’t due to excess aggregate demand, but rather an increase in the money supply.
The most often used money supply measure, M2, increased from $15.38 trillion in February 2020 to $21.86 trillion in March 2022 — an increase of 42%. Unsurprisingly, inflation began to be a problem, rising to a level not seen in four decades, as output was not growing at near that rate. Then the money supply began to decrease, with M2 now having fallen by $885 billion or 4.1% since July 2022. As a result, we have seen a decline in inflation. The annual U.S. inflation rate slowed for a ninth consecutive period to 5% in March 2023, the lowest since May 2021 and down from its recent high of 9.1% in June 2022.
While the Federal Reserve will argue that the decline in inflation has been due to the Fed raising the interest rate, the decline in inflation has been due to the decline in the money supply. Raising the interest rate results in a decrease in productivity and output by reducing the amount of machinery and other production-increasing goods. Reducing output is not a solution to inflation. Rather increasing output relative to growth in the money supply is the solution to inflation.
The Federal Reserve also subscribes to the idea that increases in wages cause inflation. An increase in productivity or a reduction in the supply of labor, however, will result in wage increases. Rather than heralding the unemployment rate being at its lowest level in 50 years, the Federal Reserve views this as a driver of inflation.
A further problem with the misdirected policy of increasing interest rates, especially at such a rapid rate, has been its effect on the banking system. Increasing interest rates result in a decline in the value of bonds. If a bank is keeping its assets in U.S. Treasury bonds, something that should be secure, it will see the value of its assets declining. If a depositor thinks the bank’s assets are declining, he or she may decide to take his or her money out. And if a number of people decide to do that, the bank will be forced to sell its bonds at falling prices. You end up with the Fed having to deal with the failures of banks such as First Republic Bank and Silicon Valley Bank.
Instead of raising the interest rate, the Federal Reserve should focus, as Milton Friedman argued, on maintaining growth in the money supply consistent with the growth in output. The heightened interest rate hasn’t accomplished what the Federal Reserve hopes to accomplish. Instead, it’s damaged the value of holdings of pension funds and has been detrimental to the savings of residents across the country.
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Gary Wolfram is the William Simon professor of economics at Hillsdale College and the author of A Capitalist Manifesto.