(Drivebycuriosity) - The Federal Reserve is postponing the due interest rate cuts, even though the US economy is cooling. Apparently the authority focuses on the Iran War, the resulting oil price spike and the belief that the war will cause more inflation in the US. I think they are mistaken. Geopolitical events and turbulences on the volatile oil market are not the business of a central bank.
“Inflation is always and everywhere a monetary phenomenon”, declared Milton Friedman. The money volume, the amount of money available in the whole economy, restricts how much people can spend. If they - for in instance - pay higher prices for imported goods, then they purchase fewer of them or they spend less for other goods & services.
No More Helicopter Money
Friedman got forgotten in the recent decades but the recent inflation wave confirms him again. The hot inflation at the begin of this decades was caused by a deluge of money in the years 2020 & 2021. Then the Biden administration flooded the economy with stimulus checks in the value of trillions of dollars to fight the Covid19 recession (American Rescue Plan). The government checks got financed by massive bond purchases by the Federal Reserve (Quantitative Easing, known as QE1,QE2 & QE3).
The government money landed directly on the bank accounts of the Americans, blowing up the money volume M2 (bank notes & coins & short term deposits at banks). Milton Friedman described this as helicopter money (cato.org ). As a result in 2021 & 2022 the US money supply M2, the engine of the inflation, jumped 40%. Unfortunately the money deluge met a constrained supply of goods & services partly - partly because of Covid19. So the price level inevitably had to jump and the inflation rate (first derivation) went up.
Causal Relationship
The causal relationship between the money supply and inflation was already recognized by Nicolaus Copernicus! The astronomer explained in the year 1517 why "too much money" causes inflation. Copernicus` "quantity theory of money" is based on observations: Early in the 16th century Spain conquered today`s Latin America and looted the silver stocks. The Spaniards send the precious metal to Europe where it was printed into coins and used as money.
As a result the European money supply jumped, but the supply of goods & services did not change much. The flood of money raised suddenly the demand for scarce goods & services and caused a jump of the price level.
Elaborated studies by Milton Friedman, Karl Brunner, Allan Meltzer and many other economists (known as Monetarists) confirmed Copernicus & the quantity theory of money. They described in the 1960s elaborately how and why the inflation rate follows the growth rate of money with a time lag (causal connection).
Historical Precedent
Today the US inflation is constrained by the slowly growing US money supply. M2 advanced in March just 4.9%. There is not much range for inflation. Therefore rising prices of oil & oil products create another headwind for the already weakening US economy and might even cause a recession.
There is some historical precedent for oil spikes contributing to a downturn in the economy writes the bilello.blog:
1973-74: Arab Oil embargo led to a spike in Oil prices, and the US economy fell into recession from 1973-75.
1979-80: Iranian Revolution led to a spike in Oil prices, and the US economy experienced a double-dip recession (1980, 1981-82).
1990-91: Gulf War led to a spike in Oil prices, and the US economy fell into recession (1990-91).
2000: Oil prices spiked near the dot-com bubble peak and the US fell into recession in 2001.
2007-08: Global demand pushed the price of Crude Oil up to a record $147/barrel, and the US economy experienced its worst recession since the Great Depression
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The 2007-08 oil price explosion was caused by the notorious Iran sanctions and the fear that Tehran will close the Strait of Hormuz, blocking the oil transports from the Arabian suppliers (I describe it here). And pundits like Goldman Sachs predicted that the price of oil could jump to $200.
Today the US economy is already cooling and stressed by the ongoing trade war and the sharp tariff hikes. In the fourth quarter US economic growth (GDP) already slowed to 0.7%. The weak job market is another signal of distress. Sharply rising oil prices create another headwind. When corporations and households have to spend more money for gasoline & other oil products they have less money for other expenses and need to reduce their purchases of goods & services. In 2008 for instance some households stopped servicing their mortgages and other debts in order to pay for their gasoline bill.
If the Fed would continue to cut her interest rates soon this step would encourage investing in a difficult time and lighten the stress for the already tattered US economy.
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