Economics: Why The Fed Should Cut Her Interest Rates Tomorrow

 (Drivebycuriosity) - Many expect in order to fight inflation the Federal Reserve will hike her interest rates tomorrow. The Fed has an inflation target of 2%.

I disagree. I think the Fed should decide for an interest rate cut, maybe of a quarter percent point. I see 3 reasons for that.

 

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1. Inflation has peaked and is dropping swiftly. Whole sale inflation, the growth rate of producer prices, is even falling faster.

 

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2. Monetary growth - the engine of the inflation - peaked already February 2021 (with plus 27%). Since then the monetary growth rates have been falling and turned negative in December 2022. In the recent months the money supply was shrinking! "We have never seen money taken out of the economy like this in our history" ( twitter.com).

Today`s high inflation rate was caused by a flood of money in the past. In 2020 & 2021 the US government flooded the economy with stimulus checks in the value of trillions of dollars (American Rescue Plan), supported by huge bond purchases by the Federal Reserve. The government money landed directly on the bank accounts of the Americans, blowing up the money volume M2 (bank notes & coins & deposits at banks).

Over two years the US money volume M2 jumped about 40% as a result. The money deluge met a constraint supply of goods & services, partly because of Covid19. It is no surprise that prices increased so much (marginalrevolution).

The causal connection between money and inflation is known since the 16th century at least. Nicolaus Copernicus described already in the year 1522 how "too much money" causes inflation. His "quantity theory of money" is based on observations:

The Spaniards had conquered today`s Latin America and looted the silver stocks. They send the precious metal to Europe where is was used as money. As a result the European money volume jumped, meeting a restrained supply of goods (agriculture, hand works) &  services. The flood of money raised suddenly the demand for scarce goods & services and caused a rise of the price level.

Milton Friedman, Karl Brunner, Allan Meltzer and other economists described already in the 1960s the causal  connection between money and inflation.

 

3. The banking crisis was partly caused by the sharp rise of interest rates, which send prices of bonds south. Banks, who used a large part of their customer`s deposits to buy huge amounts of bonds, made high losses (bad risk management). Bank customers lost their trust in some banks and demanded their deposits back.   

If the Fed would tomorrow announce an end of the interest rate hikes - or even better a cut - the authority would give the banks some relief and strengthen the fragile sentiment on the financial markets.

Fingers crossed.