Taps Coogan – March 10th, 2023

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Dr. Judy Shelton, controversial former Fed Board Nominee, Senior Fellow at the Independent Institute, and frequent critic of the Fed’s excess reserve regime, recently spoke with CNBC’s Joe Kernen to detail why she believes that the Fed’s entire framework for understanding the interaction between monetary policy and the economy is wrong.

Some excerpts from Judy Shelton:

“I don’t think (a more hawkish stance) is justified. I think that the Fed’s model is not working. It’s certainly not working the way that Fed policy makers thought that it would. Last August, Chair Powell said that the Fed was going to aggressively use its tools to equilibrate demand and supply, that it would bring pain to households and businesses. And the way his model was supposed to work was, to reduce aggregate demand, the Fed would raise interest rates and that was supposed to reduce economic growth and that would cause more unemployment or, as he likes to say, softer labor conditions. But what’s happening now is people have been going back to work productively, growth has been decent…, demand is sustained, and, instead of questioning the assumptions of the model, which goes to the very constructs the Fed has on the relationships between economic growth, inflation, and unemployment, they are doubling down. So their formula is really collapsing into an axiom of ‘the higher the interest rate, the lower the inflation’ and that could be exactly wrong because I think they are effecting supply more than demand. “

“If you are causing unemployment, you would have people, who are now producing goods or providing services, out of work but who are still receiving… severance payments or government unemployment… If you are causing businesses to increase the cost of capital, that will go to the bottom line… If the Fed went to astronomical rates, let’s say 10%, but the fiscal transfers, because of excess spending by Congress continues to feed inflation and aggregate demand, then there is nothing the Fed can be doing that’s helpful… The Fed needs to acknowledge the role of Congress in this and I know that Chair Powell has kind of shrunk from doing that unlike prior Fed Chairs. Certainly Volcker was willing to say that balancing the budget was essential to getting inflation under control.”

 

In the opinion of yours truly, Dr. Shelton is right where it matters but wrong about some of the mechanics at play. She is right that the Fed has adopted ‘the higher the interest rate, the lower the inflation’ axiom and she is right that that is not an optimal model for understanding inflation. As she notes, the best evidence of the disconnect is the fact that the Fed has managed to tighten monetary policy considerably without causing increasing unemployment yet.

She is also right to point to continued massive deficit spending as an all-important factor that the Fed refuses to acknowledge for ideological reasons. Virtually every member of the FOMC has been a vocal member of the ‘spend now and worry about deficits later’ camp for years. 

That doesn’t, however, mean that tightening policy and creating a hurdle rate for investment is a bad thing. The argument for the Fed pausing is not that lower interest rates are preferable (which she seems to be implying), but that higher interest rates are unsustainable and going to lead to a return to even lower interest rates.

The Treasury has not issued net new Treasury debt since the start of the year and has spent about $613 billion out of the Treasury general account because of the debt ceiling impasse. That has fully offset all of the quantitative tightening the Fed has done so far. What that proves is that, if the Federal government ran a balanced budget (all other things being equal), the Fed could tighten policy without causing a recession. Of course, we don’t run a balanced budget and, when the debt ceiling theater ends, there is going to be a liquidity crunch of epic proportions.