Interest rates are a sideshow in the Fed drama

The Fed has already cut rates, in effect, from its official policy stance of 5.375%. That’s what the Fed’s communications strategy was designed to accomplish. Chairman Jerome Powell has promised substantial rate cuts in 2024 since late last year. And the U.S. stock market has subsequently increased in value by $12 trillion. Broad financial conditions are considerably easier today than when rates were at zero in March 2022.

The Fed’s other monetary-policy tool—asset purchases—is conspicuously absent from the public discussion. It works differently from the conventional interest-rate tool. The Fed’s giant, unwieldy financial holdings amount to about $7.3 trillion. That’s where the real money is found.

When I joined the Fed in 2006, the central bank’s assets were about $800 billion, representing around 6% of gross domestic product. The Fed was an important government institution, but the scale of its operations was limited and the scope of its responsibility circumscribed. It did its best work without applause and without the audience at the edge of its seats. The Treasury Department was on the front lines of policymaking, debt funding and bill paying. Congress decided the level and allocation of spending.

The 2008 financial meltdown and the 2020 pandemic caused a fundamental, persistent and I fear permanent change. When the crises hit, the Fed expanded its power and influence mightily. Interest rates were rightfully cut to zero to lessen the economic hit. But more economic support was required. At the height of the 2008 shock, the Fed created a new monetary-policy instrument, quantitative easing, to cushion the economy and restart financial markets. The Fed bought hundreds of billions of Treasurys and mortgages on the open market for years.

When the pandemic struck a decade later, the central bank went even bigger and bolder, buying trillions of new assets, including risky private corporate bonds whose acquisition had never previously been countenanced. In a break from past practice, the Fed also called for massive new fiscal spending. The Biden administration and Congress happily obliged. Conveniently, the Fed bought much of the new outstanding debt issued by the Treasury.

The Fed, however, has proved a fickle master. At the height of each shock, it promised to unwind its emergency-era policies when the crisis abated. The economy recovered, employment strengthened, and financial markets boomed. But the Fed never quite got around to disposing of most of its added heft. Today, the Fed’s holdings equal about 26% of gross domestic product, an order of magnitude larger than 2008.

The Fed rationalizes its bloated balance sheet as a simple matter of financial management. In another ahistorical decision, its leaders say that monetary policy requires large excess reserves, since, otherwise, lending and credit markets would go astray. The Fed’s sway over the stock and bond markets, power over the largest banks, and influence over the dollar are hard to overstate. The Fed is no longer the backstop to the financial system on a dark day. It’s the dominant player day in and day out.

The Fed’s policy regime matters, importantly, to the path of inflation. The Fed’s asset purchases significantly expanded the money supply. The high priests of central bank dogma might consider it blasphemy, but monetary policy has something to do with money. It’s hard to measure money, especially given changes in credit intermediation. And simple rules that track money with inflation are inadequate. But outsize changes in the monetary base and the quantity and velocity of money have an important bearing on the ultimate price level.

The surge in federal spending and concomitant central-bank asset purchases in 2021 and 2022 contributed to the harmful surge in inflation. The monetary base is up 60% since the pandemic. Another measure of money, M2, is up 36% in the past four years. The inflation surge over the same period—cumulatively about 22%—shouldn’t have been a surprise. The American people are still paying a high price for the central bank’s policy error.

The Fed shrank its balance sheet in the past few quarters, down 7 percentage points from its peak as a share of GDP. M2 is down about 3%. Lo and behold: less money printing, less inflation.

Price stability would be more easily achieved if the Fed continues to shrink its holdings. But Fed leaders have strongly signaled the opposite: that its asset holdings are approaching steady state. They argue that the fall in inflation can be traced to lower wage increases in a softer job market. In my view, irresponsible government spending and excessive money printing are largely to blame for triggering inflation in the first place.

Had the Fed recognized the inflation problem sooner, it wouldn’t have been forced to raise rates so high. Had the Fed’s asset holdings stayed smaller or shrunk faster, inflation wouldn’t have risen so high. Hardworking Americans wouldn’t now be suffering the twin indignities of high prices and higher credit costs.

A dollar four years ago can buy less than 80 cents of goods and services today. But a dollar in the stock market is worth about $1.80. Much of Wall Street applauds the Fed’s big balance sheet and monetary dominance in Washington. Households and businesses on Main Street have far less reason for enthusiasm.

Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting fellow in economics at the Hoover Institution.