The Boxed In Fed

Narayana Havenstein is for turning

by Pater Tenebrarum

Exit, shmexit…as our readers know, we have always been among those who have argued that the Federal Reserve will never truly 'exit' from its 'unconventional policies'. At least not for any appreciable period of time – which is to say, we have occasionally held that it might try to reduce or stop 'QE' or similar programs due to a misguided impression that the recovery has become 'self-sustaining' (we are using all these quote marks because we think the entire mainstream phraseology in this context either makes no sense or is slightly Orwellian). However, it would then immediately be forced to reinstate the policy again, as the long-delayed liquidation of malinvested capital would undoubtedly commence with little delay. This continues to be the situation, so we were only moderately surprised that 'QE to Infinity' was not even 'tapered'.

We sometimes discuss individual Fed board members in these pages, as there is a variety of views represented, especially among the district presidents. Of course the money printers have a huge majority, so that the handful of doubters regularly gets outvoted when it is their turn to have a vote. In addition it should be noted that their protests are usually of a token nature: they may dissent once or twice, and then they become quiet again. The sole exceptions to this rule are currently Jeffrey Lacker and Esther George, whereby Lacker is holding views that make one wonder why he even wants to be part of this abominable central planning organization. Over the past decade or so he seems to have gradually realized what enormous economic damage it is doing.

One of the regional presidents we once held in comparatively higher regard is Narayana Kocherlakota. It may be recalled that Kocherlakota once was among those dissenting with the Fed's incessant money printing due to his analysis of the labor market. We commented favorably on his views at the time – contrary to most of his colleagues he seemed to have realized that there is no such thing as 'the labor market', i.e., he acknowledged that labor isn't a homogeneous blob.

He was quite correct of course: when a major bubble unwinds, very particular problems will emerge while the economy restructures to better reflect the actual state of consumer demand and the available pool of real savings. Many workers will lose their jobs and it will be found that there are numerous mismatches between the types of labor actually demanded in the market and the skill sets on offer. Obviously, following the collapse housing bubble, all sorts of labor connected to the building industry, the mortgage credit industry, real estate agent services and so forth were surplus to requirements. In the meantime however, demand for specific labor in other sectors of the economy could not be met (for instance, railway equipment makers could not find enough skilled welders for a time). Kocherlakota concluded that money printing could do nothing about this skills mismatch. It simply takes time for these imbalances to be absorbed.

However, it did not take long for him to make a complete U-turn. We have never understood what made him change his mind, but he moved from being a 'token hawk' to becoming the most vocal supporter of more money printing.

The Lunatics Take Over the Asylum

Yesterday, Kocherlakota once again made his new views known and this time he went completely overboard. It is quite ironic that the political left – the people who allegedly speak for the working class, the poor and the downtrodden – immediately came out judging Kocherlakota's call for massive additional monetary inflation 'brilliant'.

Of course the people that continue to be hurt the most by the Fed's crazy inflationism are precisely those the political left purportedly speaks for. It is testament to the fact that decades of propaganda have put erroneous economic theories almost beyond the pale of debate – it is simply taken for granted that central planning and inflationism will 'work'.

What is so amazing about this is that even if one has little idea of the theoretical debate, the people making these assumptions are completely unswayed by the evidence to the contrary that has amassed after decades of ever greater boom-bust cycles. After all, they have have finally landed us in the 'worst economic environment since the Great Depression'. Do they believe this situation just fell from the sky, unbidden? Why are they unable to  recognize the glaringly obvious: namely that it is the end result of the very interventionism they are pining for?

It should also be noted here that such evidence has not only accumulated in recent decades: it has been accumulating ever since the first major experiments in modern paper money inflationism were conducted by John Law in France in the early 18^th century.

Here are a few key points from Kocherlakota's allegedly 'brilliant' speech: 

“One of my main points today is that this conclusion of monetary policy impotence is at odds with the behavior of inflation. To understand this point, it’s useful to look at the behavior of personal consumption expenditure (PCE) inflation over the past few years. Just to be clear, this is a measure of inflation that incorporates the prices of all goods and services, including food and energy. Since the beginning of the Great Recession in December 2007, the PCE inflation rate has averaged around 1.5 percent. This is noticeably below the FOMC’s target inflation rate of 2 percent per year. And the outlook for future inflation is similarly subdued. Thus, earlier this year, the Congressional Budget Office projected that PCE inflation will remain below the FOMC’s target of 2 percent until the year 2018.

These low levels of inflation tell us that monetary policy can be useful in increasing the rate of improvement in the labor market. Here’s what I mean. At a basic level, monetary stimulus increases the demand for goods among households and firms. This higher demand for goods tends to push upward on both prices and employment. Hence, the downside with using monetary policy to stimulate employment is that, when employment is near its maximum level, further stimulus can lead to unduly high inflation. But the data show that over the past few years inflation has been below the FOMC’s target of 2 percent. It’s expected to remain below desirable levels for years to come. These low levels of inflation show that the FOMC has a lot of room to provide much needed stimulus to the labor market.” 

(emphasis added)

And here we thought this kind of nonsense had been thoroughly excised in the 1970s. No less than eight papers debunking such 'Phillips curve' type thinking have won Nobel prizes in economics. Of course one can push up employment artificially as long as prices rise faster than wages, i.e., as long as real incomes decline. In fact, what improvement there has been in the labor market to date is probably mainly due to the fact that real incomes have plummeted.

As we have pointed out in our discussion of the 'forced saving' phenomenon, the Weimar Republic's hyperinflation period demonstrated this principle nicely. In 1922, Germany's unemployment rate fell below 1%! The problem was only that this achievement was accompanied by capital consumption on a massive scale and a constant diminution of real wages. Eventually, when the currency finally began its headlong plunge into oblivion, workers woke up and began to insist that their wages be adjusted to reflect the loss of purchasing power. So one year after unemployment had declined to below 1%, it soared to 30%.

As an aside to all of this, if employment for the sake of employment is the main goal to be pursued, no matter the consequences for the economy or society at large, the simplest way of going about it would be to erect a full-scale totalitarian command economy. Those always have zero unemployment. They also produce nothing consumers want and have no liberty, but why should central planners care? They will after all be members of a privileged class.

As an aside, much of the political left's pining for central planning can probably be explained by this: they don't care that if their ideas were fully implemented, the economy would become a stagnant shadow of its former self, since they all hope that they will become members of the ruling class and not suffer any of the deprivations others will have to become accustomed to. The 'real socialism' of the Eastern Bloc in fact demonstrated this nicely. Its ruling elites had command over luxuries common citizens could not even imagine. 

Kocherlakota then compared the current situation with that the Fed faced in 1979. What he was trying to convey by this is mainly that 'there is a problem, and forceful enough monetary policy can solve it'. Of course the two problems –  a huge decline in money's purchasing power after decades of inflationary policy on the one hand, and high unemployment on the other hand -  are of a completely different nature, so this comparison really makes no sense.

A central bank can jack up interest rates and stop printing money if it is serious about wanting to arrest a decline in money's purchasing power (as long as it is willing to endure the political fall-out). Combating high unemployment by inflating the money supply on the other hand is only certain to create an enormous boom-bust sequence. At the end of it we won't simply be 'back at square one' either – we will be far worse off (this should be crystal clear from what occurred after the Fed fought the post Nasdaq bubble recession with massive monetary pumping).

Kocherlakota then took a leaf from Mario Draghi's cook book and asserted that the Fed “must do whatever it takes” to bring unemployment down. And then he specified what 'doing whatever it takes' actually entails: 

“Doing whatever it takes in the next few years will mean something different. It will mean that the FOMC is willing to continue to use the unconventional monetary policy tools that it has employed in the past few years. Indeed, it will mean that the FOMC is willing to use any of its congressionally authorized tools to achieve the goal of higher employment, no matter how unconventional those tools might be. Moreover, doing whatever it takes will mean keeping a historically unusual amount of monetary stimulus in place—and possibly providing more stimulus—even as: 

·         Interest rates remain near historic lows.

·         Economic growth rises above historical averages.

·         Per capita employment begins to rise appreciably.

·         Asset prices rise to unusually high levels, leading to concerns about “bubbles.”

      ·        The medium-term inflation outlook rises temporarily above 2 percent. 

It may not be easy to stick to this path. But I anticipate that the benefits of doing so, in terms of employment gains, will be significant.” 

There may be temporary 'benefits in terms of employment gains' if the Fed creates an even more gigantic echo bubble than it has already done. We are willing to grant that much. Kocherlakota apparently believes these days that there should be no limits whatsoever to the Fed's monetary pumping. 'Inflation' targets? Forget about it! Asset bubbles? Who cares!

It is as if the past 20 years had not happened – as if Kocherlakota had simply erased the whole period from his memory. Does he really believe that pumping up another giant bubble will have more benefits than drawbacks? Where does it all end?

As noted above, the problem is of course that the policy has already boxed the Fed in: as soon as 'stimulus' is but decreased, the markets are throwing a fit. So onward it is, and damn the torpedoes!

However, this ultimately means that the central bank will have to go down the very path Rudolf Havenstein's Reichsbank and John Law's Banque Generale in France went down: it will never be able to stop, as stopping the stimulus policy will immediately lead to a worsening of unemployment and various data measuring 'aggregate' economic activity.

However,  there is no such thing as a free lunch, and there cannot be an 'eternal boom' by simply continuing to print, as once envisaged by Keynes. All that will happen is that the ultimate disaster will be even greater. In fact, is seems ever more likely that the next disaster will be the last one of the current monetary system.