Milton Friedman famously argued that central banks should follow a rule ensuring a constant growth rate of the money supply – also known as the k-rule.

The Federal Reserve attempted to implement a version of this rule in the late 1970s and 1980s, but with limited success. Since then, Fed officials have consistently maintained that such a rule is not appropriate for monetary policy.

However, examining the actual development in the US money supply (M2) over the past 25 years reveals an interesting pattern.

It appears the Fed is conducting monetary policy as if following a k-rule, but with a twist – it functions as a level rule. When the rule is overshot in one period, it will undershoot the target in another until the money supply returns to the stipulated level.

What’s happening is not that the Fed is deliberately targeting money supply levels, but rather that commercial banking sector money creation combined with money demand ensures the money supply grows at a rate that maintains US inflation at approximately 2% over time.

Perhaps the money supply provides more insight into whether the Fed will ease or tighten monetary policy than is commonly acknowledged.

Notably, over the past 25 years, there has only been one major deviation from this rule – during 2020-22 – yet we have now miraculously returned to the ‘old’ k-rule level.