Opinion | The Fed Ignored the Money Supply, and a Recession Is Coming

Money dominates. Broad money growth drives nominal spending. In normal times most money is created by commercial banks. When a bank makes a loan, it credits the borrower’s deposit account. The loan does not come from the bank drawing down on its reserves at the Fed. Banks can also create money by purchasing securities, again crediting the deposit account of the issuer or seller of the securities. Provided they can meet all capital, liquidity and leverage requirements, banks create loans out of thin air.

If the ability of banks to create money is impaired for any reason, the Fed can step in and engage in quantitative easing, purchasing assets on a large scale. This increases the money supply because asset purchases by the Fed from the nonbank public result in a payment passing from the Fed to the seller, which deposits the payment in a commercial bank. This is new money. In turn, the bank passes the payment back to the Fed, which credits the commercial bank’s reserve account. This is how QE increases both banks’ reserves and the money supply out of thin air.

During the global financial crisis—which we define as the period when the Fed was engaging in QE, 2009-14—commercial banks’ balance sheets were seriously impaired by bad loans to subprime borrowers and losses on securitized loans. Short on capital in an environment where capital and other requirements were being tightened, most banks stopped lending and creating money in 2008 and didn’t start lending again until 2012. Fortunately, the Fed stepped in to create money via QE.

The third round of QE ended in 2014. The money supply (M2) increased by only $3.4 trillion from 2009 to 2014, with $2.4 trillion flowing from Federal Reserve credit and a net $1 trillion flowing from bank credit. These changes resulted in a moderate M2 average annual growth rate of 6.6% over that period. Even with the Fed’s aggressive QE, money-supply growth and the resulting average annual inflation rate of 1.7% (calculated with a one-year lag) were modest.

The Great Inflation started with the Covid-19 pandemic. Commercial-bank balance sheets were in good shape, and, in the early stages of the crisis, Washington encouraged banks to lend more. Banks were ready and willing to create money, and they did. The Fed stepped in to create even more money.

As a result, M2 has risen by $6.3 trillion since the start of 2020, of which $4.8 trillion has come directly from the Fed and a net $1.5 trillion has come from the banks. M2 has increased an incredible 41% in only 2½ years—an average annual growth rate of 16.3%. No wonder the U.S. is suffering from its highest average annual inflation rate in 40 years at 5.7% (calculated with a one-year lag).

“Right now,” Mr. Powell said in a 2021 congressional hearing, “M2 . . . does not really have important implications. It is something we have to unlearn, I guess.” He and other central bankers must “unlearn” their disdain for monetary analysis before they make another egregious error. Because of their excesses, elevated inflation will continue for some time—at least 12 to 24 months.

This inflation cannot be reversed, but in its panic to raise rates and begin quantitative tightening, the Fed has, in the three months before June, allowed M2 growth to plunge to an anemic annualized growth rate of 0.1%. When broad money growth falls to near zero, nominal spending contracts and a recession begins.

If this minuscule growth in the money supply persists, a recession will start in late 2022 or early 2023. By raising M2 annual growth to around 6%, the Fed could avoid sending the U.S. into a steep recession, which would include a surge in unemployment. But, without M2 on its dashboard, the Fed is unnecessarily flying blind.

Mr. Greenwood is a fellow at the Johns Hopkins Institute for Applied Economics, Global Health and the Study of Business Enterprise. Mr. Hanke is a professor of applied economics at Johns Hopkins University.