Quit Yellen and Start Jellin’

If Ben Bernanke steps down next year as Chairman of the Fed, his successor might be Janet Yellen. A lot was written about her last week. The following Yellen quote from a recent speech was highlighted in several articles,

"With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take center stage for the [Federal Open Market Committee], even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent."

This seemingly innocuous statement deserves more attention, especially since until 1978 the Fed had a singular mandate – to use its tools to pursue price stability.  The European Central bank (ECB) also has a similar singular mandate. But the Humphrey-Hawkins Act of 1978 created a dual mandate for the Fed – including price stability and full employment as its two key goals.

While Yellen’s above quote sounds reasonable there are some who acknowledge that until 2008, the Fed acted as if it still operated largely with a single price stability mandate. Attaining full employment was a secondary objective at least until recently. Fiscal Policy was thought to be the more appropriate means to deal with employment and economic growth. There are some who believe that Yellen and some others on the board would like to permanently create more balance between the two goals – raising the stature of employment and growth in the Fed’s work. Yellen will hoist full employment above price stability for the foreseeable future.

It is understandable that national interest should be concerned about employment and economic growth. It seems reasonable to want to aim all our policy guns at this plague. But many things that seem reasonable on the surface sometimes seem dead wrong after looking into them more closely. So that’s what I want to pursue here. As you will see below, I conclude that changing the Fed’s objective to favor employment would be very risky, inefficient, and wasteful. So let’s get started.

First, note that we believed in a single price stability mandate for the US Fed for about 60 years. The ECB insisted on this single mandate and despite what appears to be some wavering recently, the ECB continues with it. There must be some strong reasoning behind the Fed focusing on price stability.

Second, recall that John M. Keynes invented something called the liquidity trap. Modern Keynesians dispensed with this extreme behavioral assumption but maintained models that always had a preference for fiscal over monetary policy as it had to do with affecting real variables like employment and output. So Keynesians didn’t think much about using monetary policy to control employment and output.

Third, Monetarists challenged Keynesians by admitting that in the short-run, monetary policy could have a very large impact on employment and output. But Monetarists insisted that these impacts were possible only if the stimulus policy was unexpected – it had to be a surprise to be effective.  In the longer-term, the effects would dissipate as the impact was fully understood. So-called Neo-Keynesians agreed that such monetary surprises had only a short-term impact. Both groups of economists agreed that part of the undoing of the short-term impacts was eventual increasing inflation and interest rates.

Fourth, much of the discussion today assumes that there is no need to worry about the Fed’s recent and future monetary explosion having an upward impact on inflation and interest rates. But history is clearly rife with examples of inflation catching up when least expected. Policymakers have been caught many times with their guards down. Inflation was not there and then it was, like magic.

Inflation is like a fire. I once had a small fire in one pot on my stove. I could not believe how quickly it spread. Once inflation spreads, the FED acts quickly to eradicate it. Episodes of extreme fed tightening have led to either pronounced decreases in economic growth or absolute reductions in output. When the fire spreads you have to bring out the big hoses – and this pretty much ruins the kitchen – until you have time to rebuild. The below link takes you to a discussion where the author points out several, dismal time periods following tight money – 1956, 1960, 1968, 1973, 1978, 1980, 1989, and 2000 http://www.econbrowser.com/archives/2006/02/should_the_fed.html

The Fed swears it will do better this time. It will know when to pull out the money in a reasonable way that does not disturb the economy. History is not on the Fed’s side. If you believe the Fed I have a fire insurance plan to sell you.

Fifth, Yellen and others are making us all take a very clear risk. Is it worth it? They say – okay, it is possible that focusing on employment today will bring more inflation sometime in the future.  But they believe that this risk looks like chicken-feed compared to the pains of the unemployed today. But again, they do not fully explain the problems of inflation. As I said above, when inflation comes it might first rise slowly and to levels that are only a little above the 2-3% range.  But experience in other countries and the US shows that once inflation starts rising it is very hard to contain. That is why countries try so hard to maintain price stability. Turkey, Brazil, and Israel are countries that experienced inflation rates above 100% per year in the recent past. Talk to someone who lived in those countries and you know why people prefer price stability.

You believe it can’t happen here and now. But notice that hyperinflation has to start somewhere. It starts at 3% and then spreads from there. And by the way it usually got going because governments could not constrain their spending and the central bank monetized and compounded these political errors.

When inflation does get started it messes everything up – workers often get higher wages but since inflation rises faster than their incomes they get lost in the dust. Interest rates rise and make creditors feel richer until they find out that prices rose faster than investment income. People spend much too much of their productive time learning how to protect their money balances as they buy cuckoo clocks and other collectibles instead of bonds and stocks and real estate. Firms prefer producing later because prices will be higher than they are today.

In short, using monetary expansion is a very risky way to target employment and economic growth. It might work for a little while but the Fed and the rest of us know that sustainable increases in the economy are not going to come until the nation’s real problems are attended to. The US faces many threats to employment and output including housing, financial, demographic, global competition, and more. The more we fiddle with expansionary monetary policy the more we raise the risk of slower growth and divert attention from the real solutions. My advice – quit Yellen and start jellin’.