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AFF Sentinel-Vol 20#15-The Fed vs. Economic Reality

Does the Fed Not Know How the Real World Economy Works?


Steve Dittmer | AFF Sentinel

Colorado Springs, CO

Originally sent to subscribers 03/28/23

There have been some very instructive writings about the Federal Reserves’ strategy and tactics in recent days. What’s interesting is that the opinions are not very supportive of the Fed’s theories or execution.


There have been comments in the past that the Fed’s models are based on Keynesian economics of the 1940s, that their models are not very predictive and neither the models nor the board of governors seem to be able to predict the near future of the economy.


Nearly free money from the Fed was working short term when Trump and a more rational Congress was in charge. Spending was not so out-of-control as it has been the last couple years, deregulation was boosting output and there was some hope that the debt could be reduced some in the near future.


President Biden and the Democratic Congress in the first two years of Biden’s term, coupled with overspending during the pandemic changed all that calculus. We didn’t need the Fed’s models to know that inflation that they termed “transitory” was not. There was the collision of demand coming off shutdowns in much of the country with supply chains purposely slowed to meet reduced demand, then supply chains hollowed out by labor shortages, exacerbated by people being paid not to work. Add those factors to massive federal spending and payments to taxpayers and the result was not pretty. And not to hard to predict.

But the Fed didn’t catch on, after not warning Congress and the administration that serious repercussions from such spending were inevitable. What good is an independent Fed if they won’t speak truth to Congress and the executive branch? Of course, they have to know the truth and that didn’t seem to be the case.

“The Fed’s misleading forecasts have contributed to the costs of reducing inflation and risk a banking crisis,” Mickey D. Levy said. “A lapse in bank supervision has compounded the problem.” Levy is a visiting scholar at the Hoover Institute at Stanford and a senior economist at Berenberg Capital Markets, (“Mistakes the Fed Keeps Making,” Wall Street Journal, 03/21/23).


Levy is harder on the Fed than we have been. Remember, the Federal Open Market Committee (FOMC) is the body that makes the decisions on the federal funds rate that sets all our interest rates.


“Through December 2021, as inflation rose above five percent, all FOMC members estimated that keeping rates at zero would achieve sharply lower inflation…In March 2022, when the Fed began raising rates, FOMC members estimated that rates would need to be raised only a modest amount. Such projections that sustained negative real rates [interest rates lower than inflation rates] would reduce inflation defied history.”

Levy holds that the Fed’s errors were “largely analytical,” particularly its flawed modeling of the economy and its theory that it could “manage inflationary expectations through forward guidance.”


Remember, Levy’s research is based on the FOMC’s published reports.


The Fed’s model “failed to predict the stimulative and inflationary effects of more than $5 trillion in deficit spending (more than 25 percent of GDP) accommodated by zero interest rates, “ Fed purchases of half the new Treasury bonds and a “40 percent surge in M2 money” [supply] compared to pre-pandemic.

“This error is hard to understand,” Levy said.


Capital understatement.

Levy has much more to say about the Fed’s miscalculations and failures to respond to realities, like waiting to raise rates until full employment was reached when in the real world, employment was tight, wages were rising and inflationary expectations were rising.


He called for a thorough analysis of what happened by inside and outside experts, a repair job on the Fed’s modeling, the Fed’s paying more attention to what district banks are experiencing and more independent thinking among the FOMC members.


Judy Shelton is a monetary economist, a senior fellow at the Independent Institute and a long-time critic of the Fed and author of "Money Meltdown." She pointed out what appear to be problems with Fed Chairman Powell’s beliefs about supply and demand. Powell’s statements indicate he does think the Fed can affect demand, with higher interest rates, slower growth and softer labor markets.


“We can’t really affect supply with our policies,” Powell said elsewhere.


Shelton pounces on that theory ("The Fed's Policies Haunt Financial Markets, Wall Street Journal, 03/23/23).


“How can higher interest rates not influence the formation of new businesses or the viability of existing ones?” she asked. “When the cost of borrowing increases beyond what can be absorbed or passed on while remaining profitable, enterprises close down and economic output is reduced.”


Shelton’s theory is that resolving inadequate supply relative to heightened demand -- i.e. inflation -- would be better handled by providing a “more stable platform” for growth, through maximum employment and strong economic activity.


Shelton paraphrased a report from the St. Louis Fed this way:


“…when capital is allocated through meaningful price signals that reward long-term investment in productive economic opportunities, people become gainfully employed and real growth leads to greater prosperity.”

It’s really not too hard to see how the Fed gets things wrong. Bad interpretation of bad data run through bad fancy models yields lousy results. The problem is, we have to live with their ineptitude, or perhaps better put, pay for it.


We have to hope somehow they figure out their mistakes and learn, although there are no such indications that could happen from history or the analysts we’ve quoted here.


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