Is Elon Musk right to trust the Fed?

In an interview with The Economist last week, Elon Musk claimed that “money won’t matter” in a decade, based on the theory that AI will make everything so abundant that no one will need to purchase anything. Taken at face value, this is of course nonsense. But as a thought experiment, it is worth reflecting on.

Before money in its current form existed, goods were exchanged for other goods. A baker would go to market with bread, but they could only trade for what was being sold at the time. If there was no fish, then it was eggs for dinner. But if they could trade bread for coins, they could potentially go to the market the next day, when the fishermen were in town. Now, their bread could be sold for anything at any time in the future.

This comes with risk. There might be a storm, and the next day the price of fish at the market could be higher with fishermen unable to bring in supplies, and the baker might regret not buying eggs the day before.

In Musk’s scenario, the volume of eggs and fish and bread would be so abundant that they would be all but worthless.

But as we moved towards this scenario, rather than money not mattering, it would become incredibly valuable. The baker would try to sell their bread immediately and save their money because each day it could afford more eggs and fish. 

No one would want to borrow because, with the value of money rising so quickly, it would be impossible to pay back. Nominal interest rates would collapse.

This, though, is assuming the money supply is fixed. If whoever controls the money is expected to increase the supply in the future to make sure it does not become too expensive, then people might still be happy to borrow in the present.

Nowadays, this is a lot easier. Later in the interview, Musk predicted “deflation will be the issue” in the age of AI abundance but explained, correctly, that the Federal Reserve can just “create money in the database”.

Whatever rate people are willing to borrow at reflects their expectations for the real economy but also how they expect the Fed to react to potential future inflation.

Last week, the market started to worry that it did not know what the Fed would do. And its worry is not deflation, but inflation. The new chair Kevin Warsh has made a point not to offer forward guidance and gives as few clues as possible: “Many of you might be interested in our reaction function; we’re interested in the reaction of financial markets.”

Warsh argues that the Fed wants the market to provide it with information about what direction it should move interest rates. His theory is that if the Fed doesn’t say or do anything other than reiterate the 2 per cent inflation target, then the bond market will reflect what interest rates “should” be and the Fed can follow.

This, though, relies on the market knowing that the Fed won’t make any mistakes, and to know how likely someone is to make a mistake, it helps to know how they would react to any given situation. And the market is increasingly losing confidence in how the Fed will react to rising prices. As a result, in response to Warsh’s press conference, the yield on short-dated Treasuries fell, while the 30-year rose to 5.2 per cent, its highest level since 2007. 

Musk doesn’t think money will become worthless. Actually, he is predicting it will become extremely valuable, and the Fed’s task will be to keep bringing its value back down.

We don’t agree with Musk’s techno-optimism, but at least Musk has a clear view of how he thinks the Fed will respond to his predicted future. This can’t be said for the bond market. Not only is it expecting inflation, but it is losing confidence in the Fed’s willingness to bring it back down.

One prediction The Squeeze can confidently make is that in a decade, money will still matter and so will the Fed’s credibility.