The recent changes in the Federal Reserve's monetary policy, away from accommodating budget deficits, is contributing to a cool-off of inflation. However, it is too early to expect a return to the more conservative monetary policy regime of the Alan Greenspan era when U.S. inflation often stayed within the 2-3 percent band.
A main reason to expect a long path back to monetary conservatism is the size of the current money supply in the U.S. economy. Figure 1 reports the ratio of M2 money supply to current-price GDP, on a quarterly basis. The four marked episodes are commented below.
Figure 1
Episode 1 is the Greenspan-era monetary accommodation after the terrorist attacks on September 11, 2001. Episode 2 is the first Bernanke-era QE, which was launched in response to the financial-crisis elements of the Great Recession of 2009-2011. Episode 3 is the second major QE episode under Bernanke. It ended when Yellen succeeded Bernanke as Fed chair—see the flattening of the ratio right after Episode 3.
Episode 4 is the Powell-era monetary expansion in response to the 2020 pandemic. As a result of this expansion, there is now approximately $3.50 in M2 supply for every $1 of GDP. This should be compared to $2.75 in 2016 and $2.20-2.40 in the 1960s, 1970s and 1980s. The monetary restraint during the 1990s brought money supply down to less than $1.90 per $1 GDP.
Excess money supply means over-supply of liquidity in the financial system. This in turn leads to cheap financing of equity-market investments and speculative bubbles. It also leads to excessive, cheaply funded deficits in the government budget.
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