One Fed Experiment Ends And Another Begins

One Fed Experiment Ends And Another Begins

Yesterday the Federal Reserve rates 75bps, the biggest single-meeting increase since 1994. Two days ago, the markets had incorporated an expectation for 50bps.

After a well-placed Wall Street Journal article that somehow everyone on the Street knew was a warning from the Fed, the markets immediately priced 75bps. I’ve never seen anything so dramatic, nor as blatantly insider. Giving weight to a “Fed mouthpiece” journalist who is assumed to have great sources at the Fed is a time-honored tradition. But I have never seen the entire market re-price with a virtual 100% certainty overnight based on a news article (especially when the last thing the Chairman had said on the subject of 75bps was fairly dismissive, not long ago).

Ergo, I’m fairly confident that the article was only the public whisper. We will never know, and they like it that way.

Cynicism aside, yesterday’s rate hike and marked an important moment when the central bank finally admitted that is higher and likely will stay higher than they previously have assumed (gone from the statement was a note that “the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong”), rates will have to go higher—although they still don’t anticipate raising rates above inflation, according to the ‘dot plot’—and that they probably can’t make this omelette without breaking some eggs.

Powell still refused to cop to the fact that this was a total policy error, and completely identifiable in real time. It’s always amazing to me that when policymakers make massive errors they always seem to think that no one saw the mistake coming. Greenspan said that about the tech bust. Bernanke said that about the housing bust.

But this was more than just a mistake. This was an intentional policy decision that was driven by a seductive but completely idiotic theory: the idea, promulgated by Modern Monetary Theory acolytes, that if the economy is not at full employment the government can spend any amount of money and the central bank can print it, and it will not cause inflation.

The last two years were an experiment, testing that proposition. Massive government spending, financed by bond sales that the Fed promptly bought, was nothing more than MMT and lots of people said so at the time, including this author. In January 2021, right after the first stimmy checks went out, I wrote this:

So I expect that as things go back to normal, inflation will rise – and probably a lot.

This is the test! Modern Monetary Theory holds you can print all you want, with no consequences, subject to certain not-really-binding constraints. The last person who offered me free wealth with no risk was a Nigerian prince, and I didn’t believe him either. I will say though that if MMT works, then we’ve been doing monetary policy wrong for a hundred years (but then, we also leached people to cure them, for hundreds of years) and all of our historical explanations are wrong – and someone will have to explain why in the past, the price level always followed the GDP-adjusted money supply.

…and I’d also said something like that in November 2020. And in March 2020. And I certainly wasn’t alone. The meme that “MMT” stood for “Magic Money Tree” was well-traveled.

So this is in no way unforeseen. The prediction in advance was that this behavior would provoke very high inflation. And the MMTers said “pshaw.” They were wrong, and that experiment is over. The next person who mentions MMT, you are entitled to run out of town on a rail.

That’s the good news. [I will say that I did not believe the Fed would get religion this quickly, but then they also haven’t been punished by asset markets yet for turning hawkish. Still, I didn’t really think the Fed would get to 1% before they’d start reversing course, and I was definitely wrong on that!]

But now the bad news. We are starting a new experiment, and unlike the last one this experiment isn’t as obvious. The Federal Reserve is now, for the first time, trying to control high inflation by changing only the price of money, with no pressure at all on the quantity of money.

Always before, the Fed changed interest rates by putting pressure on reserves. Banks that wanted to continue to lend had to bid up those scarce reserves, and so interest rates rose. As I’ve written frequently (and even talked about in my book “What’s Wrong With Money?” six years ago!), that isn’t how it’s done today. Banks live in a world where lending is not reserve-constrained at all, and only capital-constrained.

Changing interest rates, without putting pressure on reserves to drag down money growth, is an experiment just like MMT was an experiment. The Fed has models. Oh yes, they have models. Gobs of models. Given what we’ve just gone through, how much confidence do you have in their models?

Here’s the thing. Raising interest rates, if banks have unlimited lending power, probably[1] means more money and not less. That’s because banks are very elastic when it comes to making profitable loans. Give them more spread, or a higher yield over funding, and they will lend a bunch of money. On the other hand, borrowers tend to be less elastic. If you’re a consumer who has an 11% consumer loan, and it goes up to 12%, is that really going to make you borrow less? Mortgage origination is one place where you’d expect to see an elastic demand response to higher rates, but less than you might think when home prices are rising 15% per year. In short, if you don’t restrain banks by pressuring reserves, I suspect it’s very likely that you get more lending, not less, with higher interest rates.

But we don’t really know one way or the other.

What concerns me now is that at least with MMT, we knew it was an experiment. It may have been a stupid experiment, or merely an excuse to do ‘transformational’ things in response to the COVID recession, but we knew we were doing things we had never done before.

When we talk about interest rate policy, though, there aren’t a lot of people who think the Fed is doing anything new. People think that the Fed always operates by raising interest rates, because we “know” that “tightening policy” is synonymous with rate hikes. The problem is, that’s a mental shorthand. That isn’t, in fact, the way the Fed has historically operated. When the Fed was doinking around with inflation between 1% and 3%, the precise mechanism didn’t really matter—the Fed’s actions probably didn’t have any meaningful effect one way or the other.

Now, however, we are in a dreadfully important time. There’s a reason that NASA tests rockets without anyone aboard, before they strap anybody to it. We, though, are all involuntary participants in this experiment.

Hope this one ends better than the last one.

[1] Fine, fine, this is speculation on my part too because I haven’t done it either. But my forecasting record is better than the Fed’s.

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