During a meeting this week (Nov. 1-2), the Federal Open Market Committee of the Federal Reserve Bank (often called “the Fed”) once again raised the rate at which the Fed lends to other banks, this time by 0.75% to about 3.75%, and indicated an intent to continue raising rates at future meetings. This has been a rapid run-up from near 0% in February.
The Fed’s purpose in raising rates is to slow down the economy until prices stop rising.
They may slow down the economy, but they won’t reduce inflation any time soon, if history is any lesson.
More than 40 years ago, respected economist Paul Volcker took over as Chair of the Fed and raised interest rates to control inflation. This slowed demand and led to a couple of painful recessions, but that was not Dr. Volcker’s purpose. He was explicitly reining in the money supply, which had grown too fast under his predecessors, and at that time his only tool to do this was raising the Fed’s interest rate. For decades afterward, the Fed kept to a policy of stable growth in the money supply, leading to low inflation, low interest rates, and strong growth in the U.S. economy. Financial markets developed a faith that the Fed would keep inflation under control. This faith gave the Fed additional flexibility to provide modest stimulus in the form of a burst of extra money in the economy when demand lagged; markets had faith that the extra money would not cause inflation, and the Fed rewarded that faith by returning the money supply to the long-term trend.
In 2020, as we have discussed before, there was a short but severe recession caused by COVID-related supply shutdowns (not lagging demand). The Fed responded by stimulating demand with a massive 42% increase in the money supply in 22 months, using both low interest rates and “quantitative easing.” As we have also said before, this monetary stimulus was an overdose of the wrong prescription.
We were optimistic in April that the Fed was taking steps to manage the money supply, even though Fed Chair Jerome Powell (a lawyer and banker by training and profession – the first non-economist to chair the Fed since before Dr. Volcker) made no mention of the money supply.
We were less optimistic when Chairman Powell, speaking in September, said that the money supply is not a factor in inflation, and certainly not a tool he is considering. The only tool he is looking at to address inflation is the interest rate, and slowing the economy with high interest rates is his only route to inflation reduction. “The relationship between the money supply and inflation … has been much more unstable than it was in Friedman’s day,” Chairman Powell said, and “monetary aggregates [i.e., the money supply] don’t play an important role in our formulation of policy, and we don’t think they’re generally a good way to think about policy or inflation.”
This is the conclusion that “modern monetary theorists” have come to, partly because of the market’s faith in the Fed’s grip on inflation over the last 40 years; this is like theorizing that a well-trained dog never needed training, because he behaves so well now. Modern Monetary Theory says that we can get all the benefits of free money created by the Fed and casually waves away concern about inflation: it asserts that monetary stimulus is a free lunch with no limit except for the capacity of the economy to produce.
This has led Chairman Powell to believe that the only way to control inflation is to squash demand in the economy until it is within the economy’s current capacity to supply. In his words, he is “strongly committed” to the objective of controlling inflation and “hope[s] to achieve growth below trend [and] bring wages back down to a level more consistent with 2% inflation.”
So what can the Fed do? If today’s Fed is doing the same thing that Dr. Volcker’s Fed did, aren’t they doing the right thing?
Yes and no.
Chairman Powell is using the same tool that Dr. Volcker used to control inflation: interest rates. When Dr. Volcker used them, they were chasing long-term rates that had already climbed to very high levels as the world had assumed inflation would continue at a rapid pace. The result was very painful, and the high long-term interest rates took years to come down to the levels we (and the economy) have enjoyed in the last decade.
But Chairman Powell has a tool that Dr. Volcker didn’t have, and he has used it for other purposes: the Fed’s asset portfolio allows for expansion and contraction of the money supply, independent of interest rates. The “quantitative easing” that the Fed undertook in 2020 – and which no one had thought of in 1980 – was accomplished by massive purchases of financial assets – including government bonds – to pump Fed-created money into the economy, even more than 0% interest rates could. As a result, the Fed is sitting on an asset portfolio worth $8.7 trillion. Selling more of those assets (“quantitative tightening”) instead of raising rates could have managed money supply growth in a more direct way than raising interest rates would, and without threatening the economy so severely. These sales would have some minor impact on capital markets, lowering prices for securities (as it would for goods and services); but that would be much less damaging than the raising of interest rates’ upheaval of the entire economy. (More on this later.)
Ironically, Chairman Powell has already begun to shrink the money supply; but it will take time for inflation to slow because, in Chairman Powell’s own words, “money growth was extraordinarily high in 2020.” If he was applying the same rules of monetary policy that four decades of his predecessors did, he would be done raising rates and accept that the excess money simply has to work out through more inflation over the next year or two.
The Fed’s interest rate could still be near zero with better prospects of managing inflation, if it had committed to unwinding more of its asset portfolio. The Fed could still return to its foundation in traditional monetary theory, which has always worked in the past, and focus on the money supply as the tool to rein in inflation. They could halt (or even partially reverse) the interest rate increases and commit to selling additional trillions of their portfolio.
Instead, Chairman Powell keeps raising rates, choking the economy to achieve inflation goals using the modern theory that he can balance supply and demand in the economy and, so, control inflation. Applying this theory will require substantial additional increases in the interest rate, given the robust demand reflected in the still exceptionally large number of job openings in the U.S.
Modern Monetary Theory and Chairman Powell will be inextricably linked to this recession; and we have little prospect of above-target inflation ending before 2024.
So how does all this affect farmers?
First, short- and long-term interest rates are high and rising. In recent years, interest expense has been about 5% of farm cash production expenses. Farmers will be facing interest rates double and triple what they were just a few years ago, with corresponding increases in interest expense; high interest rates, caused by both high inflation and the Fed’s steps to address inflation, led to the farm debt crisis in the 1980s. A doubling or tripling of interest expenses now could cause similar pressures, especially for any farmer already committed to new investments, beginning farmers or farmers forced to borrow for succession. If history is a guide, it could take years for long-term interest rates to come back down to where they were for the last decade. (For additional discussion, see this report from the University of Illinois Farm Doc program.)
Second, higher interest rates tend to lower property values, including farmland values, which would make worse the debt trap of higher interest rates and lower farm returns.
Third, rising interest rates will raise the cost of all debt, including government debt, which will ultimately cost the taxpayer and limit the government’s flexibility to provide assistance in a debt crisis.
Fourth, inflation is slashing the purchasing power of American consumers, and weakening the economy, which both undercut demand for farm products and lowers prices.
Fifth, inflation undermines the real value of USDA programs, including the value of reference prices and budgets for most commodity programs.
Sixth, the aggressive interest rate increases by the Fed are making the dollar attractive to foreign investors and strengthening the dollar, which undermines U.S. agricultural export competitiveness.
Seventh, a Fed-driven recession in the U.S. is bad for the global economy, which will also undermine U.S. agricultural exports.
Farmers have a lot at stake in the actions of the Federal Reserve Bank, just as they did 40 years ago.
Note: This Market Intel report has benefited from public and private discussions with Dr. Steve Hanke of Johns Hopkins University. In July 2021, he and John Greenwood predicted the current inflation with startling accuracy. His long discussion with Jon Stewart explaining the current situation can be seen here.