When it comes to monetary policy, the commotion is rarely where the real action is.
The Fed cut its interest rate target range to 3.50 - 3.75 percent. This was largely expected. However, Fed governors were divided about the direction monetary policy should go. Decisions are usually unanimous, which means the three dissensions are causing a stir.
But while Fed infighting can be entertaining, the interest rate decision shouldn’t be the story. Longer-run money supply trends matter far more for economic performance.
Here’s something interesting. The Fed has engaged in what economists call “quantitative tightening” since spring 2023. It’s permitting balance sheet runoff by not replacing securities that mature. As a result, total assets have fallen from about $8.7 trillion to $6.5 trillion today.
But the broader money supply hasn’t shrunk. In fact, it’s growing. M2, perhaps the most common figure cited by economists, rose from $20.9 trillion to $22.3 trillion over the same time period. And the rate of growth is picking up. While the money supply was actually shrinking in spring 2023, it’s now growing at 4.6 percent per year.
Broader monetary aggregates, which include more assets and weight them by how liquid they are, tell a similar story. We’ve gone from shrinkage two years ago to about 4.5 percent growth today.
How can the money supply be growing ever-faster while the Fed is reducing its security holdings? The answer is that the banking system isn’t meaningfully constrained by Fed asset purchases anymore. The Fed can have a short-run effect on the rate of return on safe assets through its interest rate policy. But loans, investments, and other important financial-intermediary activity performed by the banking system respond more to credit demand than Fed policy.
This puts Fed policymakers in a tricky spot. Money supply growth is having its predictable effect: dollar depreciation. Inflation is creeping back up. It’s back in the neighborhood of 3 percent.
At the same time, unemployment is rising. At 4.4 percent, it’s still low by historical standards. But rising joblessness amidst broad-based price growth will force central bankers to make unpleasant tradeoffs.
This has serious implications for the road ahead. If inflation continues accelerating while unemployment rises, the Fed will face a difficult choice: dig deeper into the toolkit to fight inflation and risk recession, continue business as usual and watch prices spiral. Neither option is palatable. Both would further damage the Fed's credibility after the inflation fiasco of 2021-2023. The stagflation of the 1970s taught us that credibility, once lost, is extraordinarily costly to rebuild. We can’t afford to keep making the same mistakes.
The Fed's predicament stems from a fundamental misunderstanding of its own influence. What ultimately matters is the banking system's willingness to create money through lending—and that depends on economic conditions, regulatory constraints, and credit demand, not Fed interest payments to banks. Monetary policymakers are more often market-followers than market-leaders.
The real lesson is that central bankers should be much more humble about what monetary policy can accomplish. The Fed doesn't control the money supply as directly as textbooks suggest. It can't fine-tune the economy. And the more officials pretend otherwise, the more painful the eventual reckoning will be.
Instead of focusing on rate decisions and internal squabbles, we should be asking deeper questions: Can the Fed actually deliver the strong labor markets and stable prices it promises? If not, we need to start thinking about institutional reforms before the next macroeconomic crisis is upon us.
