Why does anyone believe the Fed can control inflation via changes in the Fed Funds “policy rate,” the overnight lending rate that the Fed can control the most.
If this constantly repeated claim were true, it would show up in the data in the form of a close correlation between inflation and the Fed Funds rate. Look at the first graph below.
Graph 1: Low correlation between Fed Funds Rate and CPI since 1983
We do see some co-movement from 1975 until about 1983, and then it stops. It is very difficult to detect even a correlation, never mind causation for the next 40 years. Inflation stays in a range first from roughly 1-5%, then well below 5% all the way from 1990 to 2021, spanning 31 years. Meanwhile the Fed Funds rate hopped up and down with no discernible impact on inflation. Amazingly, from 2009 through most of 2017, the Fed rate was below 1% and for much of the time near 0%. There was virtually no inflation.
Graph 2 paints an even more dramatic picture, albeit using an inflation statistic the Fed started only in the early 1980s.
Graph 2: Low correlation between median CPI and Fed Funds Rate Since origin of series
The general idea behind the claim that the Fed can control inflation via its policy rate seems to be that the Fed raising the policy rate will cause other, more economically meaningful rates, to rise as well. That, in turn, will contract credit and stifle business activity, bringing down inflation because then we will all be poor. As graphs 3 and 4 show, there is not much evidence for this either.
Graph 3 shows the yields on the one-year and 10-year treasuries against the Fed Funds rate. Unsurprisingly the one-year rate tracks the “policy” rate pretty closely, but the more market sensitive 10-year rate does not. From about 1983, the 10-year rate goes into a long-term steady decline with none of the bumpiness of the overnight rate. What this really looks like is the market slowly gaining confidence that inflation has subsided and, therefore, the premium on long-term money could fall as well.
Graph 3: The one-year rate tracks the overnight rate, but the 10-year rate does not.
Graph 4 below gives further confirmation. Both corporate bond yields and the CPI ignore the bumpy blue line of the Fed Funds rate. Instead, the bonds — far more responsive to the market and business conditions — cautiously follow inflation downward. The longer inflation stays within the 0-3% range it established in the early 1990s, the more corporate rates fall, a measure of the markets’ confidence that inflation had pretty much gone away.
Graph 4. Neither Corporate Bonds nor the CPI Care What the Fed Does.
Even more confirmation comes in graph 5. High-yield bonds are much more volatile than AAA bonds, reacting strongly to business conditions. The high-yield bonds don’t appear to be affected much by the Federal Funds rate at all.
Graph 5: And High Yield Bonds Really Couldn’t Care Less
Even mortgage rates, which, being relatively more influenced by bankers, might be expected to follow a policy rate closely, don’t seem affected much by the Fed Funds rate, even though they tend to share a correlation with inflation.
Graph 6: What about Mortgage Rates? Nope.
If the Fed is far less relevant than it wants us to think, what is going on? Why did we get rising prices in 2021-2022? Why did they stop rising, and why have they started again?
The answer, which we have known since Reagan, is that inflation is not driven by monetary policy or by the Fed, but by the health of the productive economy. Extraordinarily destructive restraints were place on that economy, especially the bizarre policy of paying people not to work or produce anything.
Unproductive economies yield weak currencies. Just ask the ghosts of Lenin and Stalin. They were obsessed with monetary policy — Stalin was a monetarist before Milton Friedman — but the new ruble after new ruble collapsed because they destroyed the Russian economy, previously one of the fastest growing in Europe.
As the economy went back towards normal in 2022, prices moderated quickly.
What about now?
For the most part, U.S. economic policy remains far superior to most of our competitors. President Reagan’s core policies remain in place and President Trump’s corporate tax cut continues to pay huge dividends. On the other hand, the Democrats are in power and regulating for all they are worth. According to the American Action Forum, quoted in the Wall Street Journal, in two years the Biden administration has imposed 517 “regulatory actions,” with some $318 billion in total costs, worse even than the Obama administration’s $208 billion in costs in its first two years. In his entire term, Trump’s additional regulatory burden came to just $64.7 billion.
Federal regulations are gouging at least $2 trillion a year from the U.S. economy, some 8% of U.S. GDP, according to the Competitive Enterprise Institute (CEE). That comes to some $14,684 per family more than is extracted by the federal income tax, the CEE reported.
In truth the cost is probably much greater. The centerpiece of Biden regulation and Biden economic policy is the “green” drive to “electrify” the economy, forcing massive misallocations of capital from productive to destructive activities.
The $7,500 or so tax in subsidies for each electric car sold is, all by itself, one of the most self-destructive policies ever undertaken by a nation. We have no prospect of generating enough electricity to support 300 million electric cars; the grid is degenerating not improving. We don’t have an adequate supply of rare earth metals to make 300 million car batteries. And, if we did, the Biden administration won’t let them be mined.
Congress is handing the U.S. semiconductor industry $50 billion it does not need to build new chip fabs. But where will they be built, given the pervasive hostility of the federal and most state governments to the energy and chemically intensive manufacturing chips require?
Is all lost? No. Human ingenuity conquers if we allow it. Israel, at least, still spurs innovation. From the more than a dozen simply astonishing start-ups we saw on our recent visit come solutions to just about every burden the Democrats can create, from turning electronic waste into the world’s most productive rare earth “mines” in the world, to hyper-conducting new materials that will massively improve energy efficiency, to cures for cancer so we can all work longer and harder to pay Biden’s bills.
Those are the kind of breakthrough innovations we write about in the Gilder Technology Report — and show you how to invest in as well. It is a new world baby and the left can’t stop it from coming.
George Gilder and Richard Vigilante