There  is a lot of confusion about the Fed, its interest rate policy, and the tools  the Fed has at its disposal to create money and inflation. In other words, the  tools to increase or decrease the money supply and increase or decrease  interest rates.

Let  me say from the onset that I am a big fan of Milton Friedman, but I am not  a monetarist. Monetarism holds that an increase in the money supply will cause  inflation and a decrease in money will cause deflation. It proposes a monetary  rule that would establish a rate of increase of somewhere between 3 and 5%, and  that the Fed should hold that rate firm perpetually. Monetarism  claims this will lead to low and stable prices. The theory is only half  correct. Sometimes this theory works and sometimes it doesn’t.

Monetarism  is accepted by most conservatives and libertarians, regardless that in today's  economy it has been proved wrong. The Fed increased the money  supply the most in history, some 3.5 trillion dollars over the  last many years and should have produced soaring prices, an artificial  boom, and a crashing dollar. But instead, disinflation set in along with  stagnation, the exact opposite of what monetarism predicted.

(For  a further explanation of why that happened, see my commentary

Click here: Why Prices Are Not  Skyrocketing -  written in 2010.)

In  the 70s, a period of rising inflation rates, the Fed fostered inflation by  increasing the money supply dramatically and consistently. They did so in two  ways, by buying notes and bills from banks, thereby injecting the banking  system directly with money; and by lowering reserve requirements, freeing  up money for banks to lend out. Under the Federal Reserve System, when  banks loan out money, that money becomes leveraged as it's loaned to the tune  of about 10 to 1. This leads to more money chasing fewer goods and to rising  prices.

The  key to creating inflation (if that's what a government wants) is to  leverage money; to keep interest rates artificially low; and to do it  progressively. In the 70s it worked like a charm. We saw the inflation  rate rise progressively from 2% to 14% during the decade, causing havoc and  destruction throughout the economy - just as Milton Friedman predicted it  would. He fought almost single-handedly to educate the public that it was the  Federal Reserve that caused inflation by artificially increasing the money  supply. Friedman won that battle and between him, Paul Volker, and Ronald  Reagan, inflation was defeated and has never returned in that form again. The  inflation rate fell from 14% in 1980 to zero by the end of 2014.

The  reason increasing the money supply didn't work to cause inflation in the  last five years is because the money supply remained low. There was no  bank lending. There was no leveraging of money. There has been de-leveraging  instead. Banks took the money and refused to lend it out. They in effect, put  it under the mattress. And borrowers were more concerned with paying down debt  than taking on more debt. Credit expansion fell.

The  money supply in circulation has remained very tame even in the face of huge  money creation:

Only  lately, has there been the beginning of what could be a meaningful acceleration  of money and credit in circulation. What makes monetarism even more  suspect as a working theory is that the upturn in the present money supply has  only occurred as the Fed has discontinued its quantitative easing! The  answer to why that is can be found in my above commentary, which predicted that  no meaningful inflation would result from the Fed's new attempt to create  inflation. It was at best a policy to try and fight deflation. At worst it has  left a tinder box of money that potentially could ignite and explode into  real inflation if not neutralized. But, any way you look at it, monetarism did  not do what it was expected to do.

I  have always argued the virtues of a gold standard and the classical monetary  theories of Ludwig von Mises as the best way to promote a monetary system of  integrity. But unlike gold bugs, I have argued that where gold may be a good  long term investment, a return to the gold standard as a monetary system is way  too premature at this time in this particular economy. In fact, if the  gold bugs would have gotten their way and decreased the money supply and raised  interest rates in the face of massive de-leveraging, they would likely have  crashed the economy, the dollar, and the monetary system they so much want to  improve.

There  was a time, and will likely be a time again, when such hard money policies can  be employed -- but it is not today. Today, we are still in the de-leveraging  stage, not just here in the United States, but throughout the world. The  world-wide deflationary/recessionary bias holding down growth is our main  enemy, and our main focus is to put into place those policies that create  stability and allow the economy and the monetary system to heal. Only then will  growth normalize. Many of those policies are non-monetary in  nature. They consist of regulatory and tax reforms. For the first time in five  years there are preliminary signs that a return to normalization may be taking  place.

I've  argued that the Fed's Quantitative Easing - which is the buying of bonds -  is at best anti-deflationary, but impotent in the attempt to raise prices. The  following chart of the velocity of money should make that point eloquently.

If  inflation is too many dollars chasing too few goods, we are nowhere near that  point today. The velocity of money is and has been flat on its back for five  years now. The thought of the Fed raising interest rates in the world we live  in today would be dangerous in my opinion. There is no reason not to wait until  we see the economy growing, prices rising across the board, and interest rates  rising of their own accord due to real demand for money and inflationary  concerns. That would be the time to fight inflation.  It would be  reasonable as things improve to follow the market and raise short-term interest  rates as a market oriented response to rising long term rates.

So,  today it is not monetarism that we need, nor the gold standard, nor edicts and  decrees from government or the Federal Reserve. The monetary policy  we need is a free market monetary policy. If you believe that free markets are  a reliable source of information about the value of money and the health of the  economy, then there should be no reason to artificially impose higher interest  rates on society.

Remember,  the Fed is out of the market. They are not buyers of new bonds, notes, or  mortgages. Rates today are market rates, and they are among the lowest rates in  history. There is no US monetary policy at work to attempt to artificially  hold down rates as was the case over the last five years. What you see is what  you've got. And the market is saying loud and clear that we still have  historically low demand for money and commodities, and a historically high demand  for safety.

In  my view the decision to raise rates is premature. Following the markets is the  best monetary rule I know in today's world. It’s elementary my dear Yellen.

Paul  Nathan