Federal Reserve leaders always talk about being “data dependent.” Of course, their behavior in 2021 proves that is not the case. It appears the Fed’s top officials implicitly signed on to Modern Monetary Theory, that is, the printing of money to pay for excess federal government spending, in 2021.
While they likely knew that the MMT concept was not valid, they continued to play the MMT game until early 2022, with disastrous consequences.
In MMT, central bank action replaces the decisions households and capital markets would make in response to excessive federal spending. That is exactly what the Fed’s monetary policy did in 2021.
CPI inflation was already at 5.3% in June 2021 year-over- year, while the personal consumption expenditures deflator, the Fed’s preferred inflation gauge, was at 4% year-over-year.
Fed leaders didn’t lean against the mounting inflation pressures, so they are not data dependent. And there was no reason to expect Congress to show any discipline when it came to spending.
There was excess federal government spending of $2.3 trillion in 2020, $2.5 trillion in 2021 and about $2.0 trillion in 2022.
Sure, Fed officials in 2021 didn’t know about the excess federal spending to come in 2022. But they did know about the nearly combined $5 trillion of excess outlays that had already occurred.
Fed leaders did the exact opposite of leaning against that $5 trillion of excess outlays by letting capital markets decide how to respond. Instead, Fed policymakers engaged in the absurd policy of monetizing the $5 trillion by expanding the Fed’s balance sheet by nearly the same amount.
Fed Chair Jerome Powell wanted to hold interest rates at near zero and be reappointed as Fed chair, so he pulled a page from the Bank of Japan playbook and monetized the excess government spending. There is no way of knowing, but “keep the party going” may have been the message told to him by Janet Yellen, the Treasury secretary, if he wanted to be reappointed. The Federal Reserve regional bank Presidents were on board with monetizing the excess outlays policy, since there were no recorded dissents in the 2021 FOMC meetings.
It is distressing, too, that none of the regional bank presidents voted against monetizing all the new spending in 2021. They paid no attention to the excess aggregate demand situation of real economic growth running above 6% in three of the four quarters in 2021 and the resulting 2021 runaway inflation that they were monetizing.
It was obvious to anyone who gave even a cursory glance to the excess aggregate demand situation that the price level had to rise to clear the markets. Average real economic growth was approximately 2.2% from 2010 through 2019. A just-in-time global supply chain evolved to supply U.S. demand at that speed. There was no method by which the global economy could supply nearly 6% real growth or 10% nominal growth in 2021.
Everyone knew the price level had to rise to clear the markets, including Federal Reserve leaders. But Fed policymakers remained determined to continue QE and hold interest rates at zero and not allow capital markets to work.
Federal Reserve leaders must have viewed the excess Federal government outlays as a one-time event that would result in a one-time jump in the price level that would be transitory, Chair Powell’s often-used description of the 2021 inflation issue.
Inflation may have been transitory had the Fed not monetized the excess spending. Household and capital markets would have decided how to address that spending. The private sector would have almost certainly responded by running up interest rates to slow aggregate demand growth in 2021, thus tapering the inflation spike.
It is hard to believe that Fed leaders didn’t know that replacing household and capital market decisions with a central bank decision to monetize excess federal government outlays would result in a sharply rising price level for several years.
As August’s shock 8.3% jump in the CPI shows, CPI inflation will likely be around 8% this year, half of that next year and around 3% for two or three years after that. The CPI rose 4.7% in 2021.
Fed leaders may need a hard landing next year to truncate that drawn-out process of reducing inflation to their target level of 2%. A major recession in 2023 may cause inflation to hit its target of 2% again in 2024, but not without an awful lot of pain first.
Mike Cosgrove, principal at Econoclast, a Dallas-based capital markets firm, is an emeritus professor at the University of Dallas.