This is a segment from The Breakdown newsletter. To read more editions, subscribe
“Inflation in the United States is made in Washington and nowhere else.”
— Milton Friedman
When Fed Chair Paul Volcker raised short-term interest rates to as high as 22%, angry construction workers sent him two-by-fours in the mail in protest.
They had no other use for them, they explained, because his rate hikes were stopping them from building houses for people.
It was a fair point.
The recessions Volcker induced with rate hikes are credited with ending inflation in the US — but they probably shouldn’t be because raising interest rates can only slow inflation in the near term.
In the medium term, higher interest rates might even do the opposite: The Fed fights inflation by reducing demand, but that can ultimately be counterproductive.
Putting home builders out of work, for example, reduces the supply of houses and fewer houses means higher house prices.
“Today’s demand is tomorrow’s supply,” John Cochrane writes in explaining why rate hikes can be counterproductive to durably reducing inflation. “The economy needs investment and housing.”
In the long term, higher interest rates are probably no help at all.
Inflation is ultimately a case of too much money chasing too few goods and higher rates don’t change that.
Why then did it work for Volcker?
Cochrane argues it’s because “tight money in the early 1980s was quickly followed by tax, spending and regulatory reform.”
Those reforms reassured consumers and investors that the government would not have to resort to printing money to pay off its debts.
Volcker might get credit for that, too, however: It was the threat of repeated Fed-induced recessions that forced the White House and Congress to demonstrate they were committed to lowering the deficit over the long term.
In Cochrane’s view, this is the only way to durably lower inflation: “The US has to persuade people that over the long haul of several decades it will return to its tradition of running small primary surpluses that gradually repay debts.”
The Fed can’t help with that — but thanks to the legend of Volcker, everyone thinks it can.
Economist and ex-Fed board member Henry Wallich recognized this as long ago as 1975, bemoaning the mistaken belief that “deficits can do no major damage so long as the central bank does its job right.”
Volcker then supercharged that belief. He raised rates and inflation went down, so it seems like that’s all there is to it: When inflation happens, it’s the Fed’s job to fix it.
His successors have cemented that impression.
After the last FOMC meeting, for example, Chair Powell reassured markets “there should be no doubt that we will do what we need to do to keep inflation under control.”
He has to say that, of course — a big part of how the Fed keeps inflation in check is by using the kind of confident language that keeps inflation expectations in check.
But the confident language also lets Congress and the White House off the hook.
Why do the hard, politically treacherous work of raising taxes, cutting spending and promoting growth if the Fed can simply control inflation with interest rates?
In other words, we have a free rider problem: Congress and the White House don’t feel responsible for inflation, so they do feel free to run giant deficits — always, even when the economy is good.
But what if interest rates were effectively set by the White House?
President Trump has recently been terrifying economists with a campaign to end the Fed’s independence, explicitly calling on the Fed to lower interest rates in order to make the deficit easier to finance.
This is the “fiscal dominance” that economists have long warned would undermine faith in the US dollar and risk runaway inflation.
But this non-economist wonders if it might have an entirely different effect.
Is it too naive to think that if the president politicizes the Fed, politicians will be forced to take responsibility for inflation?
Volcker spooked Congress into fiscal responsibility in the 1980s, and maybe voters, once they realize that inflation is made in Congress, could do so now.
There may not be any other choice, because the Fed is not so scary anymore.
If the Fed were to dramatically raise interest rates, the first-order effect would be higher interest costs on the government’s $37 trillion of debt, which in turn creates inflation by undermining people’s belief that the debt can ever be paid off.
That makes rate hikes unsuitable as a short-term fix for inflation and counterproductive as a longer-term one — and no longer something the Fed can plausibly threaten.
Ideally, recognition of this new reality would focus politicians’ minds on the long-term fixes that only they can implement.
They will be reluctant, of course, because the fixes are politically unpopular and Congress would prefer that the proverbial two-by-fours continue to be mailed to the Fed.
But inflation is wildly unpopular, too, and if voters recognize that politicians are ultimately responsible for it, they might force them into action (or out of office).
To be clear, few economists are rooting for the president to succeed in his campaign to break the Fed, and it’s not my first choice, either.
But if you break it, you own it — and now is the time for the White House and Congress to own the inflation problem.
Get the news in your inbox. Explore Blockworks newsletters:
- The Breakdown: Decoding crypto and the markets. Daily.
- 0xResearch: Alpha in your inbox. Think like an analyst.
- Empire: Crypto news and analysis to start your day.
- Forward Guidance: The intersection of crypto, macro and policy.
- The Drop: Apps, games, memes and more.
- Lightspeed: All things Solana.
- Supply Shock: Bitcoin, bitcoin, bitcoin.
