The Fed Is Becoming Less Relevant

Newsmax_Image_091115_TheFedIsBecomingLessRelevant

By Barry Elias | Friday, 11 Sep 2015 11:40 AM

The Federal Reserve implicitly acknowledges that it is ill-equipped to fulfill its dual mandate of optimizing the levels of inflation and employment in the broad economy.

The Fed was charged with these objectives when the Humphrey-Hawkins Full Employment and Balanced Growth Act became law in 1978.

Now, the Fed believes employment is a non-monetary phenomenon — as I have and still do.

In their Statement on Longer-Run Goals and Monetary Strategy, the Fed recognizes that “maximum employment is largely determined by non-monetary factors that affect the structure and dynamics of the labor market.”

They also understand that these factors “may not be directly measurable.”

Alan Blinder, an economics professor at Princeton and a former vice-chairman of the Fed, claims the Fed is “clueless” about the growth of labor productivity. Despite lackluster growth of 0.65 percent each year on average since 2010 — and only 0.3 percent last year, excluding farming — the Fed anticipates productivity to grow at approximately 1.75 percent annually: a very unrealistic projection.

The Fed also recognizes that inflationary data and projections are not well understood. James Bullard, President of the Federal Reserve Bank, recently said, “There is definitely less confidence, a lot less confidence” in how inflation operates.

The Phillips Curve, an economic model that posits the rate of inflation and unemployment move in opposite directions — e.g., high unemployment suggests low inflation — has not been empirically accurate in recent years.

The rate of Inflation has declined less than expected following the financial crisis when unemployment hovered near 10 percent, and is now rising less than expected — currently below 2 percent — as the unemployment rate has fallen to 5.1 percent and labor demand is at record levels, with 5.8 million job openings advertised in July.

(While inflation for goods and services remain low, expansionary monetary policy has inflated financial assets, thereby increasing income and wealth inequalities to near historic levels.)

Economists are reevaluating the inflationary model based on behavioral psychology and empirical data. Simon Gilchrist, a Boston University professor, and Egon Zakrajsek, a Fed board economist, suggest when cash and credit levels dwindle during financial crises, firms may actually increase prices in the short-term, even if they risk the loss of long-term customers.

This dynamic would especially apply to essential products and services, such as food, energy, healthcare, and residential rent.

Stanley Fischer, Vice Chairman of the Federal Reserve, suggests currency exchange rates play an important role in formulating monetary policy as well.

There is now evidence that the strong U.S. dollar may not necessarily translate into lower import prices and domestic inflation in the U.S., as compared with other countries.

For a long time, many economists believed that inflationary expectations are critical in forecasting future inflation. These expectations are typically represented in bond yields, with low rates suggesting low inflation going forward. The low government bond yields of late suggest low inflationary concerns from the market, which might contradict the Fed’s intent to raise interest rates soon.

Given this information, the Fed “should be a little more uncertain about forecasting inflation than it was,” says Athanasios Orphanides, a former governor of the Central Bank of Cyprus, a Fed economist, and a professor at the MIT Sloan School of Management.

Alan Greenspan, former chairman of the Federal Reserve, says fiscal policy, or the government’s tax and spending programs, is more important than central bank monetary policy, and the Fed will “become utterly irrelevant” if lawmakers undermine their fiscal responsibilities.

The Fed has limited tools to work with. Adjusting interest rates and the money supply is insufficient to deal with fiscal issues, such as federal debt and income inequality.

Blinder believes the importance and power of the Federal Reserve is overstated, and they can only address these “around the edges.”

If they are uncertain as to the cause of price movements, how can they know when to adjust interest rates and by how much?

Further, the Fed needs to be thinking more outside the box. Unemployment levels may be less important than other parameters. In May 2004, when employment was at 5.6 percent, the Fed believed this signaled a near onset of rising inflation and the need to increase interest rates.

The effective federal funds rate then rose from 1 percent in May 2004 to 5 percent in June 2006, while the unemployment rate fell to 4.6 percent.

However, this large, rapid rise in rates precipitated the financial crisis. The quantity of outstanding adjustable-rate subprime residential mortgages was so large that many homeowners no longer maintained the income to support the huge increase in monthly debt service payments — causing significant and rapid sales to meet cash flow obligations, depressed prices, excessive foreclosures, and a dire economic recession.

The Fed also needs to be prescient of global economic developments. The recent Chinese economic slowdown may have enormous impact on emerging economies as well as the U.S. in terms of lower imports and weaker commodity and energy prices.

Monetary policy is experiencing diminishing returns, and fiscal reform is the best tool we have to resuscitate our economy. My tax proposal is a good place to begin.

© 2015 Newsmax Finance. All rights reserved.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s