[Financial Planning for the 100-Year Life] Is the Fed's Monetary Policy a "Shower Room Fool"?

Milton Friedman, a Nobel laureate in economics and former professor at the University of Chicago, proposed the concept of the "shower room fool," which is described as follows: "When you suddenly turn on the water in the shower, cold water inevitably comes out. The shower room fool turns the faucet toward the hot water side, causing hot water to flow. Startled, the shower room fool then turns the faucet back toward the cold water side, causing icy water to flow again, and this process repeats."

This illustrates that premature government economic intervention can amplify economic fluctuations. Recently, the Federal Reserve's (Fed) "shower room fool"-like monetary policy appears to be exacerbating fluctuations in the economy and asset prices.

According to Fisher's quantity theory of money, the appropriate rate of money supply growth is the sum of the inflation rate and the real gross domestic product (GDP) growth rate minus the change in the velocity of money. The broad money supply (M2) is typically used as the monetary indicator, and the consumer price index (CPI) is used as the price indicator. Analyzing statistics from 1971 to 2019, the average growth rate of the U.S. M2 matched the average sum of real GDP growth and CPI inflation.

This means that, in the long term, the change in the velocity of money was zero. In this context, when the actual M2 growth rate exceeds the sum of real GDP growth and inflation (the appropriate money supply growth rate), it can be interpreted that the Fed oversupplied money; conversely, if it is lower, the Fed undersupplied money.

In 2020, the U.S. economy fell into a severe recession due to COVID-19. Especially in the second quarter of 2020, consumption sharply declined, causing the U.S. economy to contract by 29.9% (annualized rate). To overcome the recession, the government significantly increased fiscal spending, even providing direct payments to individuals, and the Fed expanded the money supply to an unprecedented extent.

As a result, in the second quarter of 2020, the actual M2 growth rate was 28.5 percentage points higher than the appropriate growth rate. The money supply increase of over 20 percentage points continued until the first quarter of 2021. This excessive money supply significantly contributed to the short-term economic recovery. However, the oversupply of money caused inflation with a time lag. In the second quarter of 2022, the CPI rose by 8.6% year-on-year, marking the highest level since the fourth quarter of 1981 (9.6%).

The Fed's monetary policy goals are to maximize employment and stabilize prices. As inflation rose to such high levels, the Fed has been tightening monetary policy since March last year by sharply raising interest rates. The federal funds target rate, which was 0.00?0.25% in February last year, was raised by 5 percentage points to 5.00?5.25% by May this year.

Due to the tightening monetary policy, from the first quarter of 2022, the actual money supply growth rate has fallen below the appropriate level. Especially in the first quarter of this year, the actual M2 growth rate was -2.7%, 10.2 percentage points below the appropriate growth rate. The Fed abruptly turned the faucet from hot water to cold water.

This Fed monetary policy has led to a slowdown in inflation. Analyzing data since 2000 shows that the Fed's monetary policy had the greatest impact on inflation with about a seven-quarter lag. Indeed, the U.S. consumer price inflation began to decline in the second half of last year and is expected to fall further to the high 2% range in the second half of this year.

However, the sharp reduction in money supply slowed economic growth with about a four-quarter lag. Additionally, money supply significantly affected stock prices. Analyzing the past 10 years of data shows that money supply had the greatest impact on the stock index (S&P 500) with about a four-quarter lag.

The Fed's "shower room fool"-like monetary policy could cause a rapid stock market correction along with an economic recession as early as the second half of this year. This is why cautious approaches to the U.S. stock market are warranted.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University

This content was produced with the assistance of AI translation services.