The Fecklessness of the U.S. Federal Reserve

From Top Left Clockwise: Janet Yellen, Federal Reserve Chairman; Haruhiko Kuroda, Governor, Bank of Japan; Mario Draghi, President, European Central Bank
Wikimedia Commons/ US Federal Reserve, World Economic Forum, Asian Development Bank

My last report on the value of the Atlanta Federal Reserve’s instant prediction of what first quarter 2016 annualized GDP growth will be was 0.7 percent. A quick look on the Atlanta Fed’s web page publishing this number from their GDPNow forecast model shows that on April 18, the forecast fell to 0.3 percent, and the next update of GDPNow will be on April 26. Yet, I have picked up a disturbing rumor from former congressman and presidential candidate for the Libertarian Party, Ron Paul, that the next GDPNow estimate will be even worse.     

A Falling U.S. Economy

On April 19 Ron Paul quoted a GDPNow estimate for the first quarter of 0.01 percent, a number I suspect is statistically indistinguishable from zero! However, no matter whether first quarter growth ends up being zero or one percent, what low growth illustrates is the fecklessness of central banks, including the Federal Reserve, the Bank of Japan, and the European Central Bank in attempting to stimulate economic growth with easy money policies.

Paul also reported a hasty and secret emergency meeting of the Federal Reserve Board, followed by a hasty and secret meeting of the Federal Reserve Chairman Janet Yellen with President Obama and Vice President Biden, both meetings apparently a result of the falling first quarter estimates. A one paragraph White House release concerning their meeting simply stated Yellen, Obama and Biden “exchanged notes” about the economy and financial sector reform. Yet somehow I suspect neither meeting was as bland and unworried as the White House release suggests. Paul notes because of the secrecy of those meetings, there is no way to know exactly how the Fed and the White House are reacting.

In fact, it is very hard to imagine they are doing anything other than panicking over the fecklessness of their combined actions over the past eight years! Despite everything they have done, they not been able to stimulate the American economy to grow faster than a mere two percent, and even that rate seems to be currently beyond what is possible. My own leading indicators, last updated on April 1, show five bearish, six neutral, and one bullish indicators for a net score 0f -4 bearish. In addition, my newly added coincident indicator, the average monthly change of the Federal Reserve’s Labor Market Conditions Index (LMCI) shows a deteriorating economy.

How good is the change of LMCI in telling us how well the economy is doing right now? Consider the plot below, taken from the Federal Reserve staff working paper on the LMCI entitled Assessing the Change in Labor Market Conditions.

As you can see, the troughs appear pretty much centered on periods of recession, denoted by the gray shaded bands, and the peaks on periods of growth. This graph shows the LMCI as almost exactly nailing concurrently what the economy had been doing. With the change of the LMCI at its lowest level since the end of the Great Recession and falling, the Federal Reserve and the White House have a right to panic.

A History of Federal Reserve and Central Bank Failures

And it is not just the Federal Reserve that has screwed-up over all the years since the turn of century, and if truth be told, since the 1970s. One way or another Keynesians have been pushing easy money monetary policies since sometime before 1980. During the 1970s such policies espoused by the neo-Keynesians created stagflation, a condition of simultaneous economic stagnation and inflation.

Around 1980 the neo-Keynesians absorbed some of the lessons men like Milton Friedman and Robert Lucas, Jr. presented to them, and they became New Keynesians with a heightened awareness of the peril as well as for the possibilities for stimulating the economy with monetary policy. Before 1970s stagflation neo-Keynesians believed in the Phillips curve, an inverse relationship between the unemployment rate and the inflation rate. By accepting more inflation, they thought they could decrease the unemployment rate. Conversely, they thought any reduction in the inflation rate would cause increased unemployment. In no way, they believed, could high inflation and high unemployment rates occur simultaneously.

Milton Friedman taught them differently, and in so doing the neo-Keynesians became the New Keynesians. In particular, they accepted the reality the Phillips curve they so trusted could be continuously shifted away from the origin by inflationary expectations to provide simultaneous high inflation and high unemployment. The New Keynesians preferred to explain the 1970s stagflation in terms of the 1970s oil supply shocks, but the explanation could also be cast in the language of monetarism, which links the price level to the quantity of money, the velocity of money, and the total production of the economy, the GDP. The two ways of explaining stagflation are not necessarily inconsistent.

As the New Keynesians began to take over the management of the Federal Reserve in the 1980s and 1990s, they evidently thought as long as they were careful about not stoking expectations of inflation by the public and corporations, they could continue to safely use the Phillips curve. After all, U.S. inflation and unemployment rates had obeyed a Phillips curve all throughout the 1960s! (See the plot below).

The Japanese, having always been enthusiastic  Keynesians, picked up all these new ideas, and pioneered in developing yet another, brand new arrow for the Keynesian bow, Quantitative Easing (QE). This new monetary weapon allowed central Banks like the Federal Reserve to drive down long-term interest rates by buying long-term securities such as long-term U.S. Treasuries. By making the long-term bonds less plentiful on the markets, the central bank purchases would drive the bonds’ price up, thereby driving their yield down, making the long-term interest rates smaller. This tool worked like a charm, allowing Japan and later the United States to lower real long-term interest rates (the nominal rate minus inflation) down effectively to zero.

The U.S. Fed even added a new wrinkle to insure inflationary expectations would not be stoked. They did this by recapturing in excess reserves most of the money (approximately 81%) created by the Fed to buy the long-term assets. They did this by offering to member commercial banks to pay a small interest rate on excess reserves. (Excess reserves are assets deposited by the member banks that are over and above what the Fed requires.) Most of the new money created by QE never went into circulation and could not cause inflation. However, the limited amount of QE money that did leak into the economy was borrowed mostly by investing institutions and corporations, as lending standards had been greatly raised by the Dodd-Frank Act. The borrowing by corporations was exactly what the Fed intended, but the corporations did not behave the way the Fed thought they should. Believing it was becoming increasingly hard to earn a profit in the U.S. because of government policies, the companies used most of the borrowed money to buy back their own stock. This then allowed their earnings per share to increase even if their actual earnings did not. This is a very logical response in an environment where U.S. corporations have been in an earnings recession for an entire year. The result has been the very predictable stock asset bubble having been inflated by the Federal Reserve.

There have been a number of other failures of QE that have contributed to central bank failures by the Fed, BOJ, and ECB. For one thing, for reasons that are controversial, QE has been mildly deflationary rather than mildly inflationary as the central banks intended. (Remember the Fed wants to use a short-term Phillips curve to decrease unemployment by increasing inflation.) One possible, very believable cause is a separate failure all by itself. If the Fed keeps real long-term interest rates at zero, people of retirement age who normally would have shifted their retirement savings from stocks to fixed income, high grade bonds  for safety of their nest-eggs, instead either keep their money in stocks with higher risk than bonds, or they keep their assets in cash. With no bond income, the retired must spend their capital to live. This means there will be a smaller amount of capital available in credit markets for productive investment. It also means that as their capital, on which they live, decreases, the retired become a great deal more frugal. Overall demand goes down, which implies deflation and reduced economic activity.

The bottom line is the Fed, BOJ, and the ECB have all failed to stimulate significant economic growth for their countries. Yet at the same time they have paid the price of inflating asset bubbles and greatly discouraging savings for a very long time. Why should anyone save if the effective real interest rates are zero? BOJ and ECB have reacted by instituting both QE and a Negative Real Interest Rate Policy (NIRP), a “hail Mary pass” if ever there was one. Indeed, they appear to be validating Einstein’s definition of insanity. No wonder if the Federal Reserve Board and the White House are panicking! They do not know what to do should the economy go into recession.

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