The “Dark Horse” and the Bright Line: Why a Fundamental Fed Reform Is Overdue

by Pavlina R. Tcherneva, and L. Randall Wray

The return of Judy Shelton to the center of the monetary policy debate has been greeted by the financial press with a mixture of alarm and condescension. While critics fixate on her affinity for the gold standard (and with good reason), they are missing the more profound shift her presence represents: a long-overdue challenge to the Federal Reserve’s failing operational framework.

At the Levy Economics Institute, we have spent decades arguing that the Fed’s “orthodoxy”, i.e., the belief that interest rates are a precise tool for managing the macroeconomy, is a dangerous myth. Shelton’s recent advocacy for a “wholesale rethink” of the Fed’s model is a welcome development and hardly “nutty.” It also aligns with several core critiques we have developed at Levy regarding inflation targeting and bank subsidies.

The Demand-Side Delusion

The Fed’s current playbook is built on a 1970s-era preoccupation with suppressing incomes, employment and overall demand to tame inflation. As we have argued in our Levy Institute Capitol Hill series, this is a fundamental category error.

Inflationary bouts in the postwar were not driven by “excess demand” but by supply-side disruptions: energy shocks, logistical bottlenecks, and geopolitical shifts. The Fed cannot drill for oil or build clean energy and microchips by raising the federal funds rate. In fact, by making the cost of capital more expensive, the Fed actively discourages the very investment needed to expand productive capacity and resolve supply-side inflation. On this point, Shelton is right: we must stop viewing inflation through a narrow demand-side lens. To us, the real causalities of this orthodoxy have been incomes and true full employment.

The Great Reserve Subsidy

We also agree with Shelton’s focus on the Fed’s payment of Interest on Reserve Balances (IORB) to the $2.9 trillion in bank reserves. This is a massive and regressive dysfunction in the current system. However, we must be technically precise. Shelton argues that if banks had not benefited from such high interest payments from the Fed, they would “lend out” those cash balances, thereby greasing economic activity via a multiplier effect. This is not how it works, nor is this the problem with the high interest rate payments on reserves. As Levy scholars have long explained, reserves do not “leave” the banking system to be “redeployed” for lending. Banks do not lend out reserves; they create deposits when they lend, and reserves are used for interbank settlement. The level of lending depends on the state of the economy, profitability of projects, or the creditworthiness of borrowers.

High interest rate payments maybe a disincentive for banks to lend to profitable but lower-return projects, but the real issue with interest on reserves is the subsidy. By paying banks a high “risk-free” rate to hold these reserves, the Fed over time has created an enormous, regressive income guarantee for the banking sector. This is essentially a publicly funded guaranteed income to private finance that does nothing to encourage lending to the “real economy.” It is a perversion of the central bank’s role, effectively turning the Fed’s balance sheet into a source of passive, guaranteed profit for Wall Street.

Beyond Low Rates: Fragility and Oversight

Like Shelton, we too support a low interest policy. Unlike her, we insist that low rates be paired with strong bank oversight and regulation to check the inherent cycles of “financial fragility” in the banking system famously described by Hyman Minsky.

In other words, problem isn’t just the level of the target rate, but the lack of oversight. We need a low-rate environment to provide stability for long-term productive investment, but it must be paired with rigorous regulation to prevent speculative bubbles. The Fed’s primary focus should be on systemic instability and the payment system, not on attempting to “fine-tune” the business cycle through the blunt instrument of the interest rate.

The Regressive Fiscal Channel: A State-Sponsored Wealth Transfer

When the Fed pivots to a high-interest-rate environment, it effectively rewrites the federal budget. By hiking rates, the Fed forces the Treasury to pay significantly more on its short-term bills and long-term notes: payments that have now ballooned to a staggering share of federal outlays.

This isn’t just a technical adjustment; it is a highly regressive fiscal policy. These public funds flow predominantly to the wealthiest asset holders and financial institutions in the form of guaranteed interest income. At the same time, it burdens lower income households with high interest costs on their debts—their interest payments also go to high wealth households and financial institutions. While the Fed purports to “cool” the economy for the public good, it is simultaneously engineering a massive wealth transfer to the top of the economic pyramid. This direct drain on government and household budgets is a political act that must be stripped of its “technocratic” mask and brought under direct Congressional scrutiny.

Conclusion: Rethinking the Framework

Perhaps the most critical point Shelton raises is the need for reform. For too long, the Fed has operated behind a veil of “independence” that serves to shield it from democratic accountability. As our publication The Fed is Not Independent emphasizes, the Fed is a creature of Congress and is ultimately responsible to, the legislative branch.

Judy Shelton is forcing a conversation that the status quo has tried to ignore for forty years. Whether or not one agrees with all of her views (and her specific take on gold and bank deregulation should be categorically rejected), her instinct that the Fed’s framework is fundamentally flawed is correct.