Why the Fed's Rate-Hike Playbook Misses the Real Problem

When the Fed creates reserves to buy assets, it expands the money supply. That expansion funds activities that otherwise wouldn't exist – what Mises called malinvestment. The resulting price increases are the effect, not the cause.

Rate hikes do not undo that expansion. They cannot reallocate resources back to their pre-inflation uses. Percy Greaves described Mises' view of attempted repair as an auto driver who runs over a person and tries to fix it by backing over the victim in reverse.

The damage from the initial money creation is scrambled across wealth and income in ways that cannot be reversed by changing the price of credit. A higher rate stance that raises the cost of borrowing also punishes productive firms that did not benefit from the easy-money boom. The slump becomes longer and deeper because wealth-generators are squeezed alongside bubble activities.

A different approach would focus on the source: close the loopholes that let the central bank expand its balance sheet. Stop the asset purchases. Allow the money supply growth rate to fall. That would starve bubble activities of the diverted wealth that sustains them. Productive firms, now taxed less by inflation, would expand instead. The recession would be shorter and milder.

Instead, the Fed targets the CPI. That treats rising prices as the problem and tries to suppress demand across the board. The result is a policy that punishes everyone and fixes nothing.

The next Fed meeting is set for June 17-18. The minutes suggest a path that leads to more rate hikes. Whether that path changes depends on whether enough officials see the distinction between price inflation and money inflation.