The Fed’s Interest Rate Hikes are the Hydroxychloroquine of Treating Inflation

In Bad Medicine, Stephanie Kelton, Professor of Economics and Public Policy at Stony Brook University writes:

Conventional monetary policy, like hydroxychloroquine, can take a sick patient and make him even worse off.

“Conventional monetary policy” consists of the Federal Reserve raising interest rates in response to inflation. The American economy is the “sick patient.” This treatment is unlikely to work unless it causes a deep recession, according to Stephanie Kelton and other economists, including fellow scholars of Modern Monetary Theory (“MMT”).

Kelton, the best-selling author of The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy writes of Paul Volcker, appointed Chair of the Federal Reserve by President Carter in 1979 and serving until 1987: 

the Volcker-led Federal Reserve triggered the 1980-81 double-dip recession with rate hikes that pushed the federal funds rate from an average of 11.2 percent in 1979 to a peak of 20 percent by June 1981. As the recession took hold, Volcker’s policies sent the US unemployment rate soaring above 10 percent. The rate hikes also intensified crises in Latin America and across the Global South. And yet to this day, Paul Volcker is lionized for having had the “courage” to slay the inflation dragon even as his policies inflicted decades of immense pain, both domestically and across much of the developing world.

Using Naomi Klein’s term, MMT Economist Rohan Grey calls Volcker’s actions a “shock doctrine,” which caused “mass bankruptcies among credit-starved firms and households alike.” And yet, mainstream economics and history sees him as a hero for supposedly taming inflation, despite its cost in unemployment and suffering. Worse, even now the tactic of raising interest rates is regarded as the go-to way to fight inflation and is the policy of Jerome Powell’s Federal Reserve, as Egoberto’s story yesterday on Larry Summers showed.

Even if it doesn’t produce a recession, raising interest rates may prolong, rather than curtail inflation by providing increased income and spending power for wealthy bondholders. Warren Mosler, considered the founder of MMT, has called raising interest rates “Universal Basic Income for the Rich,” who hold the majority of the bonds earning higher interest after the Fed action.

John T. Harvey, a Professor at Texas Christian University describes the raising rates policy as a hope “that this will reduce the overall level of economic activity and, once people don’t have as much money to spend,” demand will cool, easing inflation.  Harvey, the self-described “Cowboy Economist,” writes of this policy: 

Stop for a second and assume that those pushing this policy don’t have “PhD” after their names. Imagine instead that someone on a street corner is yelling to anyone passing by, “Listen to me, people! Prices are rising and we are all hurting! Demand that your government lower your incomes today!” You’d rush by as quickly as possible, avoiding eye contact and keeping one hand on your wallet. What an idiot: help people afford to put food on the table by depriving them of income? Insanity.

But even worse, the great majority of the current inflation is not even caused by “people having too much money.” As Kelton notes in another Lens piece, two-thirds of recent inflation is related to “factors other than demand,” primarily supply. Specifically, only about a third of the jump—1.4 percentage points—in headline PCE inflation could be traced to demand-side factors.

Since most of inflation’s cause is related to supply, the remedies should be addressed to supply — Easing domestic and international supply chains, but also mobilizing the public and private sectors to “Make America Make Again,” as Professor Robert Hockett puts it: 

There is no reason that we can’t embark on a comparable effort right now – the project of making America make again, reclaiming our status as one of the world’s great manufacturing societies, founding and rapidly growing the industries of tomorrow so quickly that, as back in 1945, we account for leading shares of the world’s gross product and exports alike. Indeed, at this point domestic and global perils alike resemble no other time as they do the ‘40s.

Few other issues show such a stark disconnect between “conventional” thinking and the data-based analyses of MMT and other progressive scholars. The Fed is expected to raise rates again tomorrow, despite recession fears. And unlike with Hydroxychloroquine, too many in the “mainstream,” including Democrats, are on board.