February 02, 2023

Early during the inflation surge Mr. Powell argued that the inflation was transitory, and so the Fed did not act. Then as the inflation rate persisted Mr. Powell had an epiphany regarding the permanency of the inflation rate. Given the view that inflation is too much money chasing too few goods, the policy prescription was obvious – in order to curb the inflation rate, the Fed had to take steps to slow down the growth rate of the monetary aggregate, M2. To this end the Fed announced a Quantitative Tightening, QT, which would reduce the monetary base to the tune of approximately $90 billion per month. In addition, the Fed also announced a series of interest rate hikes.Once the Fed announced its new operating procedures and the proposed balance sheet reduction, those who believed the Fed expected the growth rate of M2 to decline. The data suggests that the Fed is keeping its word as far as the balance sheet is concerned. There is no reason not to expect the current decline in the inflation rate to continue. At the current 0.5% decline per month, by midyear the Fed will be close to its intended target rate. Kudos to Jerome Powell for recognizing the Fed’s previous mistake and correcting it. It is never too late for a policymaker to redeem themself. The Fed and the real economy. Even among those who believed that the Fed’s new policy would result in a reduction in the inflation and M2 growth rates, there was disagreement regarding the potential impact of the new policy on the economy. That is, whether the Fed’s QT would result in a hard or soft landing? The hard-landing scenario is largely based on the Phillips Curve which posits an inflation output tradeoff. Instead of focusing on the Fed policy of reducing the quantity of money, it focuses on the Fed interest rate policy. The soft-landing scenario is best explained in the context of simple classical economics. If money is a veil, it will have no long-lasting impact on the real economy. Its only impact will be on the economy’s price level. Hence any hard landing must be attributable to the companion policy mix adopted by the administration. Given the recent election, it is hard to fathom a tax increase or any other policy that results in a hard landing. One may argue that a government shutdown could derail the economy.

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