Does the Fed even matter?

We’ve just been through the fastest-ever rate hike cycle, with fed funds going from 0 to 5% in just 14 months. And today was a “skip” (somehow distinct from a “pause”), which means there’s likely more to come.

And yet, the stock market is at a 52-week high and US unemployment is at 50-year lows.

Worse yet: The market rally is entirely attributable to the tech sector — the sector thought to be most sensitive to monetary policy and therefore most easily manipulated by the Fed.

It’s often said that, while the exact effects of higher interest rates are uncertain, the real transmission mechanism of monetary policy is via markets: Powell talks tough and markets go down, tightening financial conditions.

But Nvidia now trades on 35x revenue. And, this morning, an AI startup founded just one month ago announced a €105 million seed round — the largest in European history — at a valuation of €240 million.

One month!

It’s enough to make me wonder whether rate hikes matter at all.?

And after listening to Warren Mosler on this recent episode of Forward Guidance, I’m now wondering whether they do matter — but in the wrong direction.

Rate hikes, he says, are inflationary.

And the way to fight inflation is to cut them.

The Voldemort theory

The idea that rate hikes are inflationary is a straightforward one: When interest rates rise, the Fed pays out more interest on bank reserves, which means they print more money.

Printing money seems like a strange way to fight inflation!?

Higher rates also means the Treasury pays more on the debt it issues, which increases deficit spending: The Federal government is likely to spend at least $1 trillion on interest this year — all of it either printed or borrowed.

?

Here it is in a picture:

Does that look disinflationary to you?

It’s of course possible that these interest payments are inflationary, as Mosler says, but that the second-order effects of rate hikes make them net/net deflationary, as everyone else says.??

The Fed’s hikes have, for example, imposed something like $1 trillion of mark-to-market losses on banks, which presumably discourages lending.?

And higher rates might, in theory, lower the velocity of money by encouraging us to park our savings in a money market fund instead of investing it in risky assets.

But how come the inflationary first-order effects never get a mention by the Fed or anyone else other than Warren Mosler??

Mosler thinks it’s because the Fed has deemed the topic too dangerous to speak of:

“I offered to give [Powell] a briefing [on] what I was thinking and the answer came back that he can’t talk to me because it would be on their logs at the Fed … and they were concerned that if it got out that he talked to me there’d be some kind of monetary collapse. A systemic collapse. So he can’t even talk about it.”

I’m sure Powell would have some alternative and entirely reasonable explanation for not taking Mosler’s call (pickleball tournament? the new Zelda?).?

But it’s more fun to think Mosler’s “Voldemort explanation” is correct: It suggests monetary policy is a belief system, like the divine right of kings: If people get the idea that the king has not been chosen by God, why would they keep listening to him??

Powell may similarly worry that if we think too hard about the real effect of rate hikes, we’ll stop listening to him.?

This would be a problem as the second-order effects of rate hikes are largely about us listening to him: The Fed says they are going to slow the economy, so we invest less and save more, which causes the economy to slow, as promised.

Losing faith in the Fed’s ability to slow the economy might therefore end the Fed’s ability to slow the economy.

Mosler thinks Powell needn’t worry: “If [the monetary system] ran on faith it would have collapsed a long time ago. I’ve seen lots of times where there was, like, no faith and it keeps going because you gotta pay taxes.”

Instead, he believes the Fed should fess up to the truth about interest rates and reverse engines on monetary policy.?

If Powell were ever to take his call, here’s what he’d advise him to say: “We’ve had this backwards and now we’re going to have to cut rates to control and fight [inflation].”

?

It’s theory all the way down?

I’m a sucker for contrarian takes, and cutting interest rates to fight inflation is about as contrarian as it gets, so I really want it to be true.

Unfortunately, it’s impossible to say, because the evidence for both sides of the argument is circumstantial: In Turkey, for example, lower interest rates appear to have caused higher inflation, while in Argentina higher interest rates appear to have caused higher inflation.

But there’s no way to say for sure.

In the US, we believe in the conventional view of monetary policy (rates up, inflation down) because Paul Volcker pushed interest rates up and then inflation went down.?

It could, however, be that he simply raised rates until inflation went down … correlation is easily confused for causation.

I’m guessing Mosler would go so far as to say that inflation would have gone down sooner if Volcker hadn’t raised rates. And as preposterous as that probably sounds, it can’t be definitively disproved.

Monetary policy famously works in “long and variable lags” — so long and variable that whenever inflation ends, the Fed will be able to say that it was their rate hikes that did it.

Which means the current rate hike cycle won’t make us much wiser.

It takes a theory to beat a theory, so the current thinking on monetary policy will reign until another theory — Mosler’s or otherwise — comes along to beat it.

Written by Byron Gilliam .

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