In modern economic thinking, there is a common belief that interest rates control inflation. However, it is actually the quantity of money in circulation that dictates inflation, not the rate at which money can be borrowed or lent. If there is a shortage of money available to borrow, even with low interest rates, inflation will not occur. Conversely, if there is an abundance of new money being circulated, prices will rise, regardless of interest rates. Therefore, money supply, not interest rates, drives inflation.
While the focus is often on what the Federal Reserve will do with interest rates, the more important question is what they will do with the money supply. The Federal Reserve has been tightening the money supply by reducing its balance sheet and selling bonds back to the economy, which has contributed to a decrease in inflation. By mopping up cash, the Federal Reserve can control inflation, as demonstrated by their actions.
The Federal Reserve has recently announced a cut in tightening, which essentially involves burning money by reducing the balance sheet. This may lead to a point where banks begin to experience a lack of cash, similar to what happened with Silicon Valley Bank. The excess money in the system is reflected in the reverse repo facility balance, which shows how much money banks are unable to find a use for and hold with the Fed. The current inflation levels align with this excess money in the system, indicating the impact of economic interventions during Covid.
The Federal Reserve’s decision to slow the reduction of its balance sheet suggests a shift towards a more neutral stance in terms of the money supply. This change may be driven by various factors such as avoiding economic risks, the upcoming election, or mitigating financial accidents. The surplus money in the economy could be intended to support government deficits. This shift towards a more neutral stance is positive for investors as it creates a more favorable market environment with the potential for asset price inflation.
Overall, the focus on the money supply rather than interest rates is crucial in understanding and predicting inflation. The actions taken by the Federal Reserve to tighten or reduce the money supply have a direct impact on inflation levels. As the Federal Reserve adjusts its policies to maintain a surplus of money in the economy, investors can expect favorable market conditions at least until the November election. This shift towards a neutral stance by the Federal Reserve benefits investors by creating a more benign market environment with the potential for increased asset prices.
