COVID-19 and the Fed’s Monetary Policy

Abstract

The quantity theory, which posits a causal relationship between money and prices, is among the oldest theories in economics. Starting in March 2020 as the COVID-19 pandemic affected the United States, money surged at a historically rapid pace. Historical experience, most recently with the Great Inflation of the mid-1960s through the 1970s, suggests that an uncontrolled surge in inflation is coming. Other factors in the intellectual and political environment are also reminiscent of the Great Inflation. The Federal Reserve has reverted to its 1950s “cost and availability” view of monetary transmission. There also exists a widespread belief that inflation is a nonmonetary phenomenon. In Keynesian terms, because the Phillips curve, which relates inflation and unemployment, is presumed to be flat, the Fed can push the unemployment rate to historically low levels. Federal Open Market Committee (FOMC) chair Jerome Powell asserts that the course of the recovery will be dictated by the behavior of the virus. That makes sense in that the recession arose as a shock to potential output. Powell and the FOMC, however, treat the recession as if it originated in a large negative aggregate-demand shock requiring extremely stimulative monetary policy. The FOMC should follow a rule that ensures that the spring 2020 bulge in money dissipates.