Updated: Jan 18
Jay Powell is enamored of Paul Volcker. What a shame The Federal Reserve Chairman does not show the same admiration for Milton Friedman.
Paul Volcker is known as the man who raised the Federal Funds rate to almost 20%. This is a false narrative. The rate was set by the market. Volcker simply stepped aside and let it happen. Money was in high demand then. Volcker introduced the certificate of deposit to bypass bank accounts whose rates were regulated.
Banks today, in contrast, are awash in cash thanks to Fed policy of the last decade. Because Quantitative Easing has flooded the banking system with cash, we are no longer in a banking regime of scarcity as existed at the time of Volcker. So banks today are not willing to pay for overnight funds. That should come as no surprise. Has anyone checked the interest rates offered on CDs by the big Fed banks recently?
Why, then, is the overnight rate rising today? Answer: Because Jay Powell says so. Despite no demand for overnight funds, an appointed government bureaucrat, trained to be a lawyer, is setting the most important interest rate in the economy by fiat at the overnight window. Inversion of the yield curve is evidence that short-term rates, heavily influenced by the Fed, are above what the market wants to pay for them.
Milton Friedman is more relevant today than Paul Volcker. The words of Milton Friedman hold as true today as they did 30 years ago: Inflation is caused by too much money chasing too few goods.
It is not just too much money that causes inflation. Trillions of dollars of Quantitative Easing in the decade before 2021 did not cause inflation. That money simply went into bank vaults. It wasn’t until deficit spending in 2020 took that money out of bank vaults and put it into broad circulation that the excess funds from QE started “chasing” goods.
At first, there was no excess money chasing goods. For much of 2020, the extra money pumped into the economy simply replaced money taken out of circulation by the pandemic shutdown. By 2021, however, the economy had started to recover. Another $3 trillion in deficit spending backstopped by $3 trillion of QE that year added fuel to the fire. The stage was set for inflation to rise. And rise it did.
To have claimed that inflation was transitory while pouring fuel on the fire in 2021 was a dead giveaway that The Federal Reserve does not understand what causes inflation. Although this error by the Fed is common knowledge today, it is worth re-visiting: if one does not understand the cause, then one is not likely to know the cure.
Money supply has not grown since March 2022. The deficit has fallen from $3 trillion in 2021 to $1 trillion this year (excluding student debt forgiveness). These two changes alone are enough to arrest runaway inflation. When the money supply is held constant, if the price of one good rises, less will be bought from the constant pool of discretionary funds. The mechanism is self-correcting when the ratio of “money chasing goods” to “goods” is constant.
But the process takes time, especially when the inflation rate is reported with a 12-month lag. Japan has held money supply growth to 3% for years, including the pandemic, and has experienced no inflation. There is no need to tank the economy and the stock market with excessive overnight rates to bring inflation down. Quantitative Tightening combined with a 2/3 reduction in deficit spending are sufficient to tame the beast given enough time.
But our Fed has little patience, particularly having erred in 2021. So we watch from the sidelines as these unelected bureaucrats, following a mistaken interpretation of what Paul Volcker actually did, proudly raise rates to kill lending, spending, and employment, not to mention jack up the Federal deficit to unsustainable levels, all for naught. If inadequate supply is driving up prices, for instance, then why constrain the labor force needed to redress supply chain shortages?
The Fed is using the hammer they know rather than relying on their new “untested” tool of balance sheet management, which is sufficient in and of itself for the task at hand. Pity the American economy and stock market.