The Fed’s in a Bind Now - March 20, 2022

Powell’s in a bind. You no doubt know that the chairman of the Federal Reserve raised the Discount Rate by .25% on Wednesday. He has rejected calls to return interest rates to normal levels for some time now, and now he is swimming to try to catch a speedboat, as his metaphor goes. 

We are now suffering the worst inflation in four decades and, like the last period of high inflation, the makings are our own fault. 

The Federal Reserve only has one broad class of tools it can employ. By purchasing securities, it drives up security prices, and hence lowers their yield compared to their dividends or bond coupon payments. The Fed has been using this policy since the Great Recession, which also occurred because of a lack of prescience over the direction of misguided market forces. 

Indeed, the Fed has been exercising this policy and hence injecting more cash into the economy consistently, even when demand has been high and interest rates, the inflation rate, and the unemployment rate have been at historical lows. 

It is time for the Fed to lead. You have probably followed the spate of resignations from the Fed as its directors were caught up in various scandals that had the specter of insider trading, and other dysfunctions. The Biden Administration has tried to appoint new members who understand the rapidly changing environment for banking and monetary policy. In one recent attempt to fill a number of vacant seats, all Republican senators boycotted a committee meeting to ensure a candidate could not advance. 

Meanwhile, the speedboat is racing away. 

You have heard me lament before a fundamental problem. Unlike many successful economies, we cannot conduct coordinated monetary and fiscal policy. The legislative and executive branches have consistently run deficits, regardless of whether the economy was too strong or too weak. Its programs have also been very poorly targeted. They often reward segments of the economy rather than seek out those opportunities that will produce superior returns for the economy overall. Instead, too often Congress acts to cultivate their base rather than their country. 

With Congress always stimulating through deficit spending, the Fed is left to stimulate a bit sometimes, or pull back a lot other times. Now the Fed finds itself having to pull back hard to nip in the bud what many economists now believe is a high and persistent, dare I say runaway, inflation. 

And yet, the Fed waited too long, even though the signs have been present for some time now, and have not pulled back hard enough. 

There was a recent candidate who recommended a more pronounced and earlier pullback of the economy, but she was not recommended by our status-quo oriented president. Others who see some of the risks associated with complacency in our badly needed transition to energy self sufficiency, and the costs associated with global warming, have been quickly dispatched from consideration. 

Well, Mr. President, the status-quo is not working. 

What will, then? 

The problem is the Fed has become a one trick pony. It believes that demand side techniques should be used to stimulate the economy when unemployment is high or growth is stagnant, and it uses demand side techniques when the economy is running too hard and unemployment is low. 

Demand side techniques are effective when the economy is overheated or risks running an inflation. The Fed can pull on the economic reins quite effectively by quashing demand. It does so by raising the interest rates, which reduces construction and new investment in productive capacity such as new factories. 

Using demand side techniques to spur the economy is like pushing on a piece of string, though. It just does not work well, as much as we try, and it creates an addictive tendency that demands more and more stimulation just to hold the status quo, just like an addict who requires larger and larger fixes to remain high. 

I wrote earlier that sometimes we just don’t feed the bear. We must incorporate rather than negate a legitimate inflationary force. We can’t stimulate our way out of such a mess by trying to neutralize its symptoms. 

Instead, the runup in prices would have been a perfect time to fix the disease, not the symptoms of the disease. If we have known for some time that the lack of investment in fossil fuels, given the correct belief that this investment’s days are numbered, we should have been working much harder to expand supply, and hence bring down prices, rather than trying, as we are now, to contract demand to reduce inflation. 

Such supply-side economics was discredited when President Reagan claimed to do it in the 1980s, but was actually running perennial deficits through tax cuts. Just as Trump did, the result of putting more cash in people’s pockets is not increased demand or true investment, but is instead asset bubbles and higher stock prices. 

Imagine if, instead of taking down the solar panels President Carter installed on the White House, Reagan had instead doubled down on research in solar, wind, pumped hydro, and batteries. China saw our mistake, and is now cornering the market on its way to self sufficiency. Meanwhile, we are trying to wean ourselves off of Russian oil. 

Indeed, the candidate recently rejected for the Fed was encouraging just that. We must encourage the economy to determine what it must look like in a couple of decades, and incentivize us to start moving in that direction now. 

Just like in 1979, and again in 2009, and now in 2022, the Fed has been a deer in the headlights, doing too little until it is way too late. If only we had raised the interest rates to normal levels once we saw the unemployment rate pull below the natural rate of unemployment. 

And, if only we had begun to encourage the redesign of our supply chain, modernize our energy network, and upgrade our chip fabrication capacity so we could raise wages at the same time as we raised incomes and increased the supply of commodities critical for our success. 

These are nuanced tools that remove some of the dents in the fenders, not sledgehammers designed to smash things beyond recognition. 

But, that requires analysis and leadership, not simplistic policies and condescension. 

I can’t blame the Fed for gridlock in Congress or the pandering to constituents by whoever occupies the executive branch. These pillars of democracy are the product of our system which is designed to purchase power. But, the Federal Reserve must still be the adult in the room. 

I understand what I am saying would risk political peril for any Federal Reserve board member who accepted the challenge. 

But, isn’t the mess we now find ourselves in, chasing both inflation and a recession, in a classic stagflation challenging in its own right? I’ll let you decide that.