Wednesday, January 12, 2022

Supply Side Matters and the Paul Volcker Myth

During yesterday's hearing to reconfirm Jay Powell as Chairman of the Federal Reserve, he responded to a question regarding inflation with the following:

“We can affect the demand side, we can’t affect the supply side. But this really is a combination of the two."

People, especially those on Wall Street, love to bash the Fed; I generally try to avoid Fed-bashing for the sake of it. That being said, I do have a problem with this statement. The Fed controls the supply (and therefore the price) of short-term credit. It absolutely affects the supply side of the economy. It's true that it can't create more supply of goods and services, but it can absolutely accommodate the businesses that do through its monetary policy. By raising rates, the Fed would be effectively raising the cost of funding for suppliers, reducing the total production capacity in the economy, thus restricting the supply of goods.

This is also part of why Fed rate hikes to "combat inflation" are insane. If you raise the cost of capital, you restrict economic production while at the same time forcing suppliers to raise prices - they have to make a profit after all. Not only that, but higher interest rates stimulates demand through the income channel.

This view is in direct contrast to the mainstream narrative. Take for example Jim Grant. He is relentlessly critical of the Fed, and like most on Wall Street, is a staunch rate hawk. He constantly rails on the likes of Jay Powell, Janet Yellen, and Ben Bernanke while placing Paul Volcker on a pedestal. Volcker is widely considered a hero, because he had the "intestinal fortitude" to relentlessly raise interest rates, thus "slaying the inflation dragon." But was Volcker in fact an arsonist masquerading as a firefighter? Consider the below chart, courtesy of Grant's Interest Rate Observer.

Paul Volcker was sworn in as Fed Chairman on August 6, 1979, and almost immediately "targets the money supply" as Grant's puts it. What's noteworthy is that, as we can see, the year-over-year change in CPI at this point matched the peak that followed the first oil shock in 1973. The growth rate of the CPI ended up coming down, without Volcker's draconian measures. Volcker's "attack" actually led to an acceleration in the rate of CPI growth. The evidence is unmistakable: Volcker's policies created the inflation he claimed to have destroyed. And yet, he is heralded as this hero in Wall Street folklore. 

As an aside - it's noteworthy that people on Wall Street complain ad nauseum about the Fed "interfering in the markets" by lowering interest rates, while simultaneously gushing over Paul Volcker's policies, even though he was the most radical Fed Chairman ever who ostensibly "interfered" in the rates market in a remarkable fashion. It goes to show that Wall Street, like everything else these days, is clearly a political institution that embraces narratives in support of its own self interest as opposed to objective facts. Wall Street is a huge beneficiary of higher rates, because high rates are subsidies for rich people. Any person of means in 1981 could put their life savings in a 30yr Treasury at a 15% yield; if they held to maturity they would have made 66x their money risk-free. How can that be described as anything other than a massive wealth redistribution scheme from the poor to the rich?

Don't get me wrong - if I had money to put to work and Paul Volcker gave me 15% annualized for 30 years risk-free, I'd be a huge fan of the guy too. But let's not kid ourselves with this myth about Paul Volcker's "moral crusade" against inflation; all he did was give out free money to rich friends on Wall Street.

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On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...