Committee to Save the World

‘The Committee will deliver price stability.’

— Kevin Warsh

The Fed is setting up a big head butting contest with Donald J. Trump. At least, that is how it looks to us. Chairman Warsh’s first big day on the job came last week, when he had to report the FOMC’s latest interest rate decision. He noted that the Fed had missed its target for five years. He went on to say that the Fed was committed to fixing that problem. The official report:

The Federal Open Market Committee approved the following statement for release by a 12 — 0 vote:

‘The Committee decided to maintain the target range for the federal funds rate at 3-1/2 to 3-3/4 percent, in support of the Federal Reserve’s dual mandate.

The Committee reaffirmed its policy of maintaining ample reserves in the banking system.

Economic activity is expanding at a solid pace despite elevated uncertainty that owes, in part, to the conflict in the Middle East. Productivity growth and capital investment are strong. Job gains have kept pace with the workforce, and the unemployment rate has changed little.

The Committee will deliver price stability.’

The final sentence has a Volckerian or Thatcherian ring to it. “We are not setting rates,” Volcker told Congress. “The lady’s not for turning,” said Thatcher. It has the sound of a door slamming shut. Don’t bother arguing about it…

Betting against Volcker proved to be an extremely bad idea. Investors had a choice. Either they could put their money on a continuation of the 1970s trend — more inflation, higher gold prices and lower bonds. Or, they could go the other way, wagering that Volcker would do no better than his predecessor, Arthur Burns. As it turned out, Volcker really did turn things around. Bonds went up for the next four decades, while the Dow went 50x. Gold, the great success story of the 1970s, went down, down, down and didn’t bottom out until the next century.

Will betting against Warsh turn out the same way?

Volcker said he was focusing on money supply, not interest rates. But by restricting money supply, the quantity of money available for lending fell dramatically…leading to interest rates in June 1981 that were ten percentage points higher than the inflation level. Lenders were then charging their best customers 21% interest…and the economy came to a near stop.

We are not yet in such a tight spot as we were then. Inflation was running at 10% a year back then…not today’s 4%. But most important, we had nowhere near as much debt. That was just ten years after the funny money system began. Total federal debt had not yet reached a single trillion dollars. The economy had not fully adapted to fake money lent out at fake rates.

And now, imposing a 20% fed funds rate would be catastrophic. The whole financial system — in the US and much of the rest of the world — would shrivel up. Because we have 40 times as much federal debt.

Today, Warsh only has to worry about a 4% inflation rate, not 10%. But if it takes a key rate of twice the inflation rate — as Volcker’s ordeal suggests — it would mean an 8% Fed Funds rate, today.

And here is where it gets interesting. For two reasons.

The first is political. Republicans have elections to win…or lose. They are counting on a burst of liquidity, either from a lower gas price or a lower Fed Funds rate — preferably both. The Hill:

Trump, GOP race the clock to bring inflation down before midterms

It is hard to tell what is going on with Iran. So we will pass over it in silence. The Fed, on the other hand, is clearly announcing its independence…and its intention to offer the president no help. Reuters:

Fed to hold rates this year, economists say, defying market bets for hikes: Reuters poll

The second reason is, let’s say, mathematical. Raising the key rate to 20%….in 1981, with $1 trillion in outstanding US debt, in a $1.1 trillion economy…was a theoretical charge of $220 billion in annual interest. Today, an 8% interest charge on $40 trillion in debt would mean an interest hit of $3.2 trillion. As a percentage of GDP that is actually lower than the Volcker shock. But in raw numbers, it is much bigger…and it would be striking an economy that is much more brittle. Federal debt is only about a third of the whole credit load.

What’s more, just as the voters are more susceptible to pressure from rising interest rates, so is the Fed more sensitive to pressure from the White House.

Ronald Reagan stood behind Volcker because he believed a free economy needed honest money. And he believed in the idea of an independent Fed, one that presidents were not meant to tamper with. Mr. Trump has no such scruples.

So, maybe the Fed won’t deliver price stability after all.