To say the least, since its inception in 1913, the Federal Reserve has had its ups and downs. One thing most people don’t know is that, prior to the invention of the Fed, other than during wars, there was almost no inflation. Various sources , including the Federal Reserve regional banks, show that the purchasing power of $1 in 1900 was the same as or higher than it was in 1800.
The Government did print and borrow money during wartime, which caused inflation during the War of 1812 and the Civil War. Between wars, when the US was often on the gold standard, the economy experienced deflation.
A gold standard basically keeps the money supply stable, but technology increases the production of goods and services, so if we don’t print more money, the average dollar price of things falls. More goods chasing the same amount of dollars creates deflation (actually “good” deflation).
Since 1913 (and the invention of the Fed), the US has experienced cumulative inflation of 3,297%. A massive difference when compared to the 1800s. Moreover, as Milton Friedman proved, it was Fed mistakes with monetary policy that caused the Great Depression. Then, in the 1960s and 1970s, because the Fed printed too much money, the US experienced double-digit inflation.
Paul Volcker took over the Fed in 1979 and fixed the Fed’s inflation problem but ended up causing two sharp recessions during that process. Alan Greenspan followed Volcker and, from 1985 to 1998, the Fed ran spectacularly good monetary policy. Then it tightened too much in 1999 and loosened too much during the dot-com crash. Excessively low interest rates from 2000 to 2005 caused a housing bubble that eventually led to the Great Financial Crisis.
In our opinion, the Fed’s reaction to that crisis (printing trillions of dollars with Quantitative Easing) was a huge mistake. The Fed followed it up with even more QE during COVID, and that easy money caused the worst inflation since the 1970s.
As we said, the Fed has had its ups and downs. One thing we don’t think enough people think or talk about is how much QE has changed our banking system and monetary policy. We’ve written about it frequently.
To summarize it in a nutshell: QE did not save the economy in 2008. We started QE in September and passed TARP in October 2008. The S&P 500 fell an additional 40% in the next six months. When we ended overly strict mark-to-market accounting in March 2009, the economy and market both bottomed.
What QE did was flood banks with reserves as the Federal Reserve massively expanded its balance sheet. So, instead of selling bonds into a free market, the Treasury sold them at interest rates well below inflation because the Fed was buying them. This money ended up as bank deposits.
To keep that money contained, the Fed raised capital requirements and liquidity rules for banks to absurd levels. The Fed also paid banks to hold those reserves. In other words, the Fed took the risk of owning Treasury debt and mortgage-backed securities while banks held risk-free reserves.
During QE1, QE2, and QE3, much of the increase in bank reserves remained within the financial system and did not translate into significant consumer inflation. During the COVID response, however, the Federal Reserve also relaxed liquidity requirements while M2 money supply grew by roughly 42%. Critics argue this made the subsequent rise in inflation far more predictable. They also contend that Chair Jerome Powell has downplayed the role of money supply growth, instead emphasizing supply-chain disruptions and other pandemic-related factors.
More importantly, the Fed’s QE has created income inequality and a divide between the young and the old. Because capitalism is often blamed for inequality, it’s no wonder almost 2/3rds of Americans under 30 have a “favorable view” of socialism.
When Jerome Powell warns about threats to Federal Reserve independence, it is worth recognizing that Fed policy itself has become deeply intertwined with politics. Expanding the money supply so dramatically over the past 18 years represents a major intervention in economic activity, with consequences that inevitably shape the political landscape as well.
We should want an independent Federal Reserve. But the Fed’s own actions over the past two decades have made that independence more difficult to defend. Massive monetary intervention, prolonged quantitative easing, and the explosive growth in the money supply have blurred the line between monetary policy and broader economic engineering.
Rather than acknowledging those mistakes, Jerome Powell appears committed to defending them. Critics argue that the Fed now needs new leadership and a clearer commitment to unwinding the excesses of the QE era. In their view, someone like Kevin Warsh would represent a meaningful shift toward restoring monetary discipline and rebuilding credibility.
Fed policy in the next few months will be interesting. The market is actually pricing in a rate hike, mainly because the CPI and PPI both exceeded consensus last month. However, the money supply is still growing relatively slowly, and housing prices are growing only 1% YOY. In other words, current inflation is likely influenced by Iran, not the money supply. We still think it is more contained than the market thinks.
Kevin Warsh has reportedly suggested a combination of quantitative tightening alongside lower interest rates — an approach that would represent a meaningful shift from recent Fed policy. Whether that strategy would succeed remains an open question, and reasonable people can debate its risks. But many believe the status quo is no longer working.
If the Federal Reserve is going to restore credibility and public confidence, it may require a different path than the one pursued under Jerome Powell. Supporters of Warsh see him as someone willing to rethink the Fed’s approach, unwind the excesses of the QE era, and move monetary policy in a new direction.
Source: Brian S. Wesbury, Chief Economist, Robert Stein, Deputy Chief Economist First Trust
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv.
Sincerely,
Fortem Financial
(760) 206-8500
team@fortemfin.com
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