Janet Yellen's Problem

Stock markets cheered Janet Yellen's maiden congressional testimony this past week, as the new Fed chair emphasized the word "continuity" and offered no boat-rocking surprises. Continuity? I assume she means a steady diet of tapered bond purchases that will lead to the end of QE3 this autumn. In other words, investors seemed to think QE has run its course, probably overstayed its welcome, and that it's time the Fed got out of the bond-buying business, since that policy isn't doing much good and may be doing harm.

Ever the Keynesian who subscribes to the non-existent, long-term trade-off between employment and inflation, Ms. Yellen did express worries about long-term layoffs and the shrinking size of the labor-participation rate. She's right about that. The labor situation is subpar.

The employment-to-population ratio is only 58.5 percent, way below its year-2000 peak of 65 percent. The participation rate is a low 62.8 percent, way below its modern average. The Joint Economic Committee estimates that jobs are 4.5 million below the employment trend line since 1960, and 7 million below Ronald Reagan's recovery rate. And average monthly private-payroll increases are only 178,000 in Obama's recovery. Compare that with the Reagan monthly rate of 330,000.

So Yellen is right to be worried about jobs. But she's wrong to think the Fed can do much about this.

Holding back growth and jobs are a series of tax and regulatory barriers that must be fixed if we are to move from secular stagnation back to traditional American prosperity. Obamacare is at the top of the list. The CBO puts the essential job loss at 2.5 million. It will be worse unless Obamacare is repealed.

Perverse Obamacare incentives will penalize industrious people as they climb the ladder of opportunity. They will lose their health-care subsidies and land in higher income-tax brackets. This steep subsidy cliff is a work trap that becomes a poverty trap.

If it pays less to work, people will work less. The Fed has nothing to do with this.

But there's more holding back the economy than Obamacare. A recent report by Tax Foundation president Scott Hodge shows that the U.S. has the worst corporate and capital-gains tax structures among the OECD developed countries. The EPA is going to destroy the coal industry. The Obama administration refuses to open up federal lands for oil-and-gas fracking and drilling, even though the energy revolution is a high-paying job creator. And the National Labor Relations Board is pushing for snap "ambush elections" to promote unionization.

But the Fed does control inflation, which is a monetary phenomenon. And I'll give Yellen and her predecessor Ben Bernanke plenty of credit for today's low 1 percent inflation rate. But I don't understand why the Fed's planners want to raise inflation to around 2.5 percent. Higher inflation is a tax on consumers, families, investors, jobs, and growth.

Paul Volcker made this point in a recent speech at the Economic Club of New York. Price stability, not monetary fine-tuning, is good for growth. And price stability, which ultimately means protecting King Dollar, requires clear monetary rules to maintain credibility.

The Fed has already dropped its 6.5 percent unemployment threshold, which would have signaled a higher fed funds target rate with cash withdrawals from the banking system. No rule has replaced this. And in the fifth year of economic recovery, you have to ask why the Fed central planners are still operating a so-called unconventional policy. Instead, they need to lay the groundwork for normalization, which means higher rates.

Professor Allan Meltzer points out that more than 95 percent of the reserves that the Fed supplied under QE2 and QE3 sit idle on bank balance sheets. That money is not circulating through the economy. M2 money growth hasn't budged from its 5 to 6 range. That $2.5 trillion in excess reserves has got to be whittled down gradually.

Yet Yellen made no attempt to pave the way for a transition to normalcy. And that includes interest rates. The Taylor rule suggests a 1.25 percent federal funds rate would be appropriate today. And a return to normal interest rates and the end of Fed credit-channeling would help the economy grow.

For most of the time under Paul Volcker and Alan Greenspan, the Fed operated a market-price rule that used gold, commodities, bond spreads, and the dollar to guide the money supply and interest rates. It worked. Many now believe a nominal GDP rule would also help. Unfortunately, Yellen has backed away from any of these rules.

It's the job of Congress and the president to create jobs by reforming taxes, regulations, and Obamacare. Ms. Yellen should limit her focus to stable prices and a reliable Kling Dollar.

I see to points to the sword. The first is that stock market valuations were at all time highs for tax purposes at year end 2013, and the second is that tapering will put downward pressure on investments for millions of American so their stocks will probably be worth less by April 15th than December 31st coupled with the tax bite! Classical Government accounting - the markets will not hold the line much longer in this environment of reduced government holding in the markets as the Federal Reserve both reduces it QE3 money printing and sells stocks previously both, now at all time highs, to cover Obama’s Obligations.

Good point, because we cannot just increase interest rates as we did in the early 80's. We have much, more debt that we did then. If rates were to go up significantly, the debt slice of the Federal budget would escalate out of control.

I am no genius, but what are the consequences of continuing Fed tapering?

We all know the markets are no akin to alcoholics for Fed funny money. If they were forced to go with less, they would have delirium tremens.

What are the short and long term consequences for what the Fed is doing, and what will happen to the US and global economies?

I would love for someone to give me a straight prediction.

Personally, I think a massive "correction" is coming to the world markets. This Papier-mâché illusion cannot be sustained.

I understand all the dynamics of 1929 and 2014 are not the same. The Fed is playing exactly the opposite role it played in 1929. But I have a really, really bad feeling.

And I'll give Yellen and her predecessor Ben Bernanke plenty of credit for today's low 1 percent inflation rate

I'll give them some credit too, but the politicians deserve most of it for strangling business with Obamacare and the worst tax structures as Kudlow correctly points out. But the Fed's role is the opposite. They are trying to destabilize (inflate) but failing. The reason that is failing is that businesses won't invest to create new jobs and push up wages. The reason businesses won't do that is because they can't trust the Fed to stabilize the currency.

What are the short and long term consequences for what the Fed is doing, and what will happen to the US and global economies?

Predictions are difficult because the Fed has created instability. The Fed policy is to get dollars moving so they move into carry trade and small commodities bubbles (or larger ones like 2008). One problem is that these expansions and contractions create a drag on the economy by tying up scarce resources. A second problem is that the Fed creates uncertainty which dissuades people from making long term investments (tying up dollars that can depreciate quickly in a commodity bubble).

The federal government ironically creates stability by maintaining huge drags on the economy which is deflationary. But the politicians also hobble the economy with a lot of their spending which is mostly payback to wealthy donors or bridges to nowhere which chew up resources needed elsewhere. Some politicians like Obama want to create wage-push inflation because they are too stupid to understand that service economies can't absorb such increased production costs. The net result will be higher priced burgers followed by a renewed call for higher wages for burger makers in a classic inflationary spiral.

The end result IMO is that the latter will win. The voters can't vote out the Fed even if they were not stupid and could recognize the damage that the Fed is doing worldwide. The voters also have the mindset that they deserve 4% mortgage interest rates even if their job and economy as a whole sucks, their house is overpriced, their government "owes" them trillions which they can't pay without printing it up. So instead of properly valued money which would force them to pay 15% interest and start to heal the economy they will choose the lower rates.

OTOH the voters can vote for new demagogues to force wage-push inflation and hand out more printed money directly. So I think that's what's in the cards in the long run but that will take a while, probably another decade or two of stagnation turning into stagflation as the US purchasing power increasingly fails to cause developing countries to devalue their currencies to gain share in our market.

Going against all of that is the inevitable march of progress in technology that will force costs and prices lower. But increasingly we will find ourselves behind the rest of the world in creating and in using those technologies.

Thank you, very good synopsis. That was excellent, and also a bit depressing because I think you are spot on. something intriguing you said about mortgages that I had not thought of: the fact that people have become accustomed to very low interest rates. I have a mortgage with a low rate, but I remember paying double digit interest on my first house. In America! we “lock in” that rate for how ever many years, usually 15 or 30. In other nations, such as those in the EU, I believe that have to renegotiate their mortgages every 5 years. I wonder......if things change on a global scale if that would change? Hmmmm. I also agree that we are headed for inflation. The government will pay entitlements, but you will be able to buy less and less with the checks.

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