Ruminations, July 31, 2013
Federal Reserve doves more accurate than hawks
— “Fed ‘doves’ beat ‘hawks’ in economic prognosticating” reads the headline in Monday’s Wall Street Journal. The reporters, Jon Hilsenbath and Kristina Peterson, have divided the Federal Reserve Board of Governors into hawks (who are, to some degree, opposed to the creation of currency under the Fed’s policy of quantitative easing – QE – and in favor of stable prices) and doves (who favor the printing of money as in QE and a target inflation rate of 2 percent).
The Journal’s reporters then checked over 700 predictions made by the Governors and rated them as to accuracy. What we can take away from this is that, since the doves have been independently proved correct more often than hawks, we should listen to them. Right? Maybe not.
Fed Vice Chairman Janet Yellin (who is being touted as Bernanke’s successor) had the best prognostication record. But it’s an interesting way of scoring. For example, when Philadelphia Fed President Charles Plosser said that QE would lead to higher inflation, “Yellen said not to worry … High unemployment and the weak economy would tamp wages and prices.” She’s pretty smart, right? Whoa! The QE policy that she favors is supposed to create more jobs and make the economy stronger. So she is evidently saying that because her stimulus will fail, we have nothing to worry about. Why would she advocate a policy she expected to fail?
And even when the doves agree, their prescriptions for actions can differ. Both New York Fed President William Dudley and Dallas Fed President Richard Fisher scored high in prognostications admit that QE has been largely a failure. Dudley said the problem is that the $85 billion in monthly purchases was far too low; Fisher said that $85 billion was way too much.
The challenge for the Fed and the economy is that QE is not sustainable for the long term. This is non-controversial. Everyone knows that the Fed can’t continue to print money indefinitely. If the Fed continues to print money, at some point the value of the dollar will plummet, inflation will soar, and people who have savings or life insurance or band investments will see their wealth fall to where it is almost worthless. Even the doves see this.
Remember last June, when Federal Chairman Ben Bernanke said that, if the economy starts to improve later in the year, the Fed might start to reduce its easy money policies, the Dow Jones Industrial averages immediately dropped over 200 points and the NASDAQ dropped almost 40 points. Bernanke quickly back pedaled saying that he didn’t really mean it and the market returned to “normal.”
The problem with the market is that the Fed has artificially inflated it – it has created an economic bubble. By keeping interest rates low, investors return on bonds is low and they have looked for alternate investments. What they found were a stock market on the way up and the Fed’s determination to re-inflate the stock market bubble. One of the goals for the Fed’s action is to increase the wealth effect.
The wealth effect happens when individuals look at their own net worth: cash on hand, stock market holdings and real estate values. When people feel wealthy, they spend more, strengthening the economy. The problem is that when the Great Recession occurred, the public optimism faded into pessimism and the wealth effect has virtually disappeared.
One of the other factors holding back the economy in spite of QE is the reluctance of companies to borrow and reluctance of banks to loan — nullifying all the extra cash that the Fed has created in trying to stimulate the economy. What would happen to inflation if the economy started to rapidly improve? The money currently sitting in the vaults would make it into the economy and inflation would take off.
So the Fed model has failed.
The same day as the Wall Street Journal article appeared, economist Robert Samuelson commented on the Detroit fiscal calamity in The Washington Post. Samuelson had this to say: the Detroit economic model for the 1950s and 1960s “was a plausible and self-serving business model: high wages, generous fringe benefits, job security (with supplementary unemployment benefits to cover workers during temporary layoffs). The compact generally bought labor peace between the companies and the United Auto Workers. Given their market power, automakers could pass most costs on to consumers. But what made short-term sense spelled long-term suicide — for companies, workers, Detroit and Michigan.”
Might the doves’ successful inflation control program be successful in the short-term and spell long-term suicide? What do you think?
Quote without comment
Former Federal Reserve Chairman Paul Volcker writing in an op-ed in The New York Times, September 18, 2011: “My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and ‘reasonable’ 4 percent [inflation] becomes 5, and then 6 and so on.”