Monetary policy can only do so much: it cannot permanently increase the wealth of a nation. That is the lesson from economic history. In the short run, the Fed can affect real variables like output and employment by expansionary monetary policy, but trying to use monetary stimulus as the primary vehicle to move the economy forward is an invitation for price inflation in the longer run.

In enacting President Biden’s $1.9 trillion relief bill, Congress should not expect a miracle. The risk is that as the Fed buys a larger share of the federal debt, inflation could increase—if there is an excess supply of money. Although policymakers are focused on the near term, it would be irresponsible to assume that most of the impact of the monetary stimulus will show up in real economic growth rather than higher inflation.

The Federal Reserve Act, as amended in 1978, states that the Fed’s primary responsibility is to achieve long-run price stability and maximum employment. To do so the Fed is required to “maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production.”

The Fed’s experiment with targeting the quantity of money (actually the quantity of nonborrowed reserves) was short-lived (1979–1982), as financial innovation and other factors weakened the link between money and prices. In 1993, Fed Chairman Alan Greenspan told Congress that the monetary aggregates were not reliable guides for monetary policy. Ben Bernanke moved to an inflation targeting regime in 2012, and last year Jerome Powell moved to “flexible average inflation targeting.”

Rather than aiming at inflation of 2 percent a year, which already deviates from “price stability” (zero inflation), the FOMC now aims at average inflation of 2 percent. That change in the monetary framework gives the Fed greater discretion to pump up money and credit. Indeed, the M2 money supply has increased more than 25 percent during the last 12 months.

Congress should not treat stimulus like a miracle drug that will mend the pandemic or believe the Fed can simply monetize Treasury debt without longer-run consequences.

Nevertheless, the steep rise in M2 should be viewed in line with the sharp decline in the velocity of money (which means a rise in the demand for money) as a result of the pandemic and near zero interest rates. Consequently, the demand and supply of money may not be that far out of line, thus reducing (for the moment) inflationary pressures. It is uncertain how rapidly velocity will return to trend after the pandemic.

Moreover, it is important to understand that, under the Fed’s new operating system (the so-called floor system), the Board of Governors can increase the interest on excess reserves (IOER) to neutralize the inflationary impact of QE. That means growth in the Fed's balance sheet mostly results in corresponding growth in bank's free reserves, with no corresponding growth in broader money measures.

Yet, with IOER near zero and the economy recovering, the Fed may be reluctant to increase the rate it pays on reserves. Consequently, there is a risk that increases in the monetary base could have a larger impact on the monetary aggregates, with implications for future inflation.

Meanwhile, a little more inflation is seen as beneficial in achieving “maximum employment” (which policymakers have never attempted to assign a numerical value, since it is unobservable), and the Fed now believes the Phillips curve is flat. Thus, policymakers believe that monetary stimulus, intended to lower unemployment, is unlikely to generate long-run inflation in excess of the desired 2 percent average.

A case can be made that, if the Fed is committed to getting the price level back to a long-run 2 percent trend path, then allowing a temporary run-up in inflation to, say 3 percent, won’t unsettle markets. But, as yet, the Fed has no plan for how to make that commitment operational, and markets are already pricing in the risk of higher inflation.

In The Spotlight

In the Fed’s playbook, there is no need to slow money growth fueled by the Fed’s large-scale asset purchase program (also known as quantitative easing or QE). As Fed Chairman Powell stated last August, “Our view [is] that a robust job market [presumably brought about by QE, near zero interest rates, forward guidance, and the Fed’s emergency lending programs] can be sustained without causing an outbreak of inflation.”

If inflation does jump above 2 percent, and the Fed tolerates that increase, at least for the short run, there will be pressure from the Treasury to cap yields, further distorting credit markets. Indeed, even a small increase in rates would frighten the bond markets and increase the cost of financing the enormous federal debt.

Moreover, if inflation were to reach 4 percent or higher as the Fed monetizes the debt, there is the risk of wage-price controls, which were last introduced in August 1971 under President Nixon and supported by Arthur Burns, then chairman of the Federal Reserve Board. Inflation in 1971 was 4.38 percent.

It is well known that transitory increases in income do not permanently lower unemployment. Permanent increases in real income and employment require higher productivity of labor and capital, better technology, and increased private investment. Institutional changes that improve the performance of markets and foster innovation are essential for robust long-run growth. Dropping money from helicopters or sending people checks financed by government fiat money does not increase society’s production possibilities or permanently improve the standard of living.

In a period of prolonged unemployment, due to a pandemic and government-sanctioned lockdowns, the Fed needs to provide liquidity to stabilize financial markets and keep nominal GDP on a level path. Nevertheless, one needs to recognize the limits of monetary policy—especially the ability of the Fed to achieve long-run maximum employment and real economic growth.

Congress should not treat stimulus like a miracle drug that will mend the pandemic or believe the Fed can simply monetize Treasury debt without longer-run consequences. If the Fed becomes a pawn of Congress to finance “stimulus” spending, it would be foolhardy to ignore the risks of inflation and the threat to economic freedom.

This article was published on the Cato Institute Blog.

James A. Dorn
About The Author James A. Dorn
James A. Dorn is Vice President for Monetary Studies and Senior Fellow at the Cato Institute. His articles have appeared in The Wall Street Journal, Financial Times and South China Morning Post. He has testified before the U.S.-China Security Review Commission and the Congressional-Executive Commission on China.

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