Steve H. Hanke is a professor of applied economics at the John Hopkins University at Baltimore, Maryland, USA.

Steve H. Hanke is a professor of applied economics at the John Hopkins University at Baltimore, Maryland, USA.

The Fed is flying blind into a recession without the money supply on its altimeter. Instead, it is using lagging indicators to justify a monetary crunch not seen since 1938. It’s just one Fed blunder after another. The result always will be surprising them and the markets. 

The strange thing is that the Fed never makes a forecast of inflation. They literally are flying blind. They don’t know what’s going on. If you are flying an airplane and the altimeter doesn’t include the money supply you’ve got a big problem.

The ninety-five percent rule implies that ninety-five percent of what we read or hear in the press is usually wrong or unreliable. The press is filled with stories about non-monetary causes of inflation. But inflation is always a monetary phenomenon. Changes in money supply cause asset price and commodity price changes. Explosion in money supply as we had in 2020 and 2021 get asset prices up and stock markets rally. All the commodities prices started shooting up. And then with another six to eighteen months, the whole economy starts changing. And then after twelve to twenty-four months, the inflation starts picking up.

To hit the inflation target of 2 % the Fed should be growing the money supply measured by M2 by about 6 % per year but at the peak it was growing by 22 – 23 %. We haven’t seen that kind rate of growth of the money supply since WW2, so of course growing three times faster than the recommended golden growth rate can’t be compatible with the desired 2 % inflation target.

Using the quantity theory of money (QTM) we see that there is a huge contraction of the money supply. Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963. 

According to the quantity theory of money (QTM), if the amount of money in an economy doubles, all else equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services and vice versa. The increase in price levels will eventually result in a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in an economy.

The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money decreases the marginal value of money–in other words, when the money supply increases, but with all else being equal or ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting for this decrease in money's marginal value, the prices of goods and services rises; this results in a higher inflation level.

How it works in reality. At first the Fed gets a huge contraction in the money supply as they get an accelerator as fast as they can and after that they put things in reverse and the money supply since last April is actually declined by 4.6 % which has not happened since 1938. This is the last time we’ve seen that kind of contraction in the money supply. Using the QTM model Prof. Steve Hanke and Prof. Greenwood projected in February this year that inflation will be down between two and five percent (the number now is 4 % in the States). The producer price index is falling at 1 % the previous week. 

The bottom line is that the inflation is yesterdays’ and not today story. We can measure inflation not by yesterday’s but with today's money supply. You can’t know it by reading the papers and all kinds of non-monetary causes of inflation as they are not relevant. The inflation forecast probably will be on the low range at the end of the year. 

The problem is the one thing in the transmission mechanism that at first asset prices start changing, then the economic activities start changing, and then inflation starts changing and the real economic activity with this kind of contraction in the money supply will see a big recession coming probably by Q1 2024. And if the Fed keeps doing what it’s doing with the reversal it will be pretty ugly recession. That includes real estate, stock market etc. That’s the US picture and as we know because of the interconnectivity of the modern world soon all the other economies will follow.

The important question is: Why did the Fed overlook the money supply? Why do they don’t focus on that? The biggest reason is that the models they have are the Keynesian models that do not include the money supply. If you have a model that excludes the main reason it is a problem. The Fed has 785 economists in the Federal Reserve System and none of them was able to predict inflation right. All they do is act post factum which is not effective. Just remember the ‘inflation is transitory’ thing and you’ll get the picture. They tried to justify it with the Covid Pandemic, war in Ukraine etc but all those are non-monetary causes. None of them is the cause of inflation but the money supply and the Fed and politicians still don’t get it. They literally are flying blind. They didn’t know what’s going on in the previous years, they don’t know what’s going on now. 

The recession is already baked in the cake because what happened with the shrinking of the money supply has already happened. With the 6 to 18 months lag before the real economic activities start changing, we’ll see the recession most probably in the beginning of the next year. What the Fed probably could and should do is try to alter the monetary policy and get the money supply growing at about 6 % per year instead of contracting it 4.6 % per year in order to reach the 2 % inflation goal without hard landing. That could mitigate the damage. However, it doesn’t seem likely that it’s in the cards and the Fed wouldn’t change it.

With a huge bear market on the way and stock market and real estate crashes, we’ll see huge adjustments in the P:E ratios and if you look at earnings as a percent of GDP it’ll be coming down big time. As a matter of fact, earnings margins are being squeezed already. But there are certain things like silver and gold which do pretty well during recessions on a historic basis. If you stack physical gold and silver in your socks most probably you will be OK. 

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