Yellen Is Increasingly Caught Between Policy and Reality

Yellen Is Increasingly Caught Between Policy and Reality
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With the count of dissenters now up to three, Janet Yellen is increasingly caught between policy and reality. The FOMC voted yesterday to do nothing yet again even though Federal Reserve officials continue to suggest that the economy itself demands something to be done. That they have been saying these same things for two years is entirely relevant if not the whole matter succinctly summed up in the same kind of indirect manner that permeates all types of bureaucratic incompetence.

The more immediate problem for the committee is inflation. Despite trillions in balance sheet expansion, it just won't respond. Because economists believe that the Federal Reserve and only the Federal Reserve has the power to expand the so-called monetary base there must be an inflationary response to QE because, as Milton Friedman showed long ago, inflation is a monetary phenomenon. Therefore, in this limited monetary view, if inflation hasn't yet appeared they are forced by ritual to expect that it will after whatever "transitory" factors holding it back are displaced.

And that is the commonality between the Fed "chickening out" and inflation, both waiting for "transitory" conditions to clear up and finally signal what every economist is certain must result. Back in late 2014 when all these claims were first being made, the public by and large was at least willing to give them a chance. After nearly two years of saying "transitory" including in every policy statement where the Fed doesn't act to validate its own position, the public might begin to wonder not just whether policymakers know what the word "transitory" means, rather that it tends to confirm what many people have long suspected about orthodox economics (hurricane forecasters have a greater success rate).

It is at this point that all of them, economists, not the public, in unison cite the exact rate of unemployment in the US. But even in orthodox conception, it is a contradiction. The Phillips Curve still looms large in neo-Keynesian mythology, meaning that if the unemployment rate is indeed an accurate measure of labor market pressures then inflation must also result. Monetary expansion plus "full employment" by all academic expectation should leave no doubt about consumer prices; they really should be if not exploding then at least moving solidly in that direction. These must be some extremely powerful "transitory" factors to overcome both QE and "full employment" together and do so in a way that really can't be classified as transitory.

To anyone not committed in ideological terms to the mathematics of all this, you might begin to question all these assumptions because in reality that is what they are. It starts with money and the unemployment rate. Taking the second first, it has been obvious for some time even inside the FOMC that the statistic is far less than ideal, if not entirely faulty. The definitions that were used to construct its modern appearance are too rigid for the times; these being the increasing evidence that we are not anymore experiencing a business cycle.

The Bureau of Labor Statistics surveys Americans and decides based on long-established criteria who is to be counted for the unemployment rate and who is to be excluded. If you haven't looked for work in a year, you aren't counted in the official labor force, the denominator of the unemployment rate. There is no argument as to that definition since it is only a definition, but that it is arbitrarily assigned is paramount. Evidence that it is no longer an appropriate standard continues to mount, starting with two years of "transitory."

Earlier this week the "left-leaning" (as described by Bloomberg) Center for Economic and Policy Research published a report further refuting the unemployment rate. There are a number of conclusions and statistics contained within it relevant to establishing the narrowness of that ratio, but the Bloomberg account of what is really the point of emphasis is sufficient here:

"Since the unemployment rate peaked in 2009 at 10 percent, about 12.7 million workers have found work, while an additional 11.8 million Americans have given up on their job search altogether. The report suggests that many currently unemployed Americans would resume work if given the opportunity."

There isn't anything startling or surprising in the figures, just more confirmation of what we already know: the recovery wasn't a recovery at all, and the only way to make it seem like one is to so narrowly define it that it leads to obvious contradictions. Of these, there is no shortage, primarily in trade and goods. According to the unemployment rate, the US is at full employment, yet industrial production has contracted for a full year, factory activity for two, and despite the sustained drop in production inventory has piled up on every level of the supply chain to heights (really depths) comparable only to 2009. Contradictions.

These have led to in many ways a stunning revival of popular economics, a revolt against economists who keep saying "transitory" or "stimulus" as if the words themselves were monetary policy. And there is some truth to the indictment, particularly as orthodox economics believes in expectations as a central focus. In QE terms, the Fed could never admit QE failed because doing so would damage the Fed and the Fed believes an all-powerful Fed is necessary, not optional, for that recovery the Fed keeps talking about. The same goes for the recovery, especially as economists actually believe that recession or negative economic conditions are as much emotion as anything tangible. In other words, they must continue to tell you it's a recovery lest you begin to think otherwise and then act otherwise.

And that leads us back to money and inflation. There are obvious complications with trying to do anything in a real economy, as it is utterly complex and not at all straightforward. Even economists who believe that a central bank can command it only believe that it will happen over time and are not at all sure how it actually works (this is a problem with relying exclusively on correlations). Inflation, at least, is far more linear; you print money, you get price changes.

Despite years and trillions, people have noticed that there isn't any evidence of money printing beyond what is reported on the Fed's H.4.1. To begin with, for all the talk about quantitative easing it is importantly odd that in the US the FOMC had to do it four times, and overseas it has likewise been done in multiples. Central bankers have noticed that the public has noticed (again, expectations) and so very quietly without any official word (explicit) the age of QE has come to its end. It is still taking place, obviously, in Europe and Japan, and in some ways it is still here in America since the FOMC while not voting to raise the federal funds rate still votes at every meeting to authorize the Open Market Desk to rollover both UST and MBS holdings obtained during those past programs.

On Wednesday, in Tokyo hours before the FOMC vote was made public, the Bank of Japan announced the results of its regular policy meeting. Though the schedule was regular the content of the discussion wasn't. Haruhiko Kuroda had previously promised that the Japanese central bank would undergo a comprehensive examination of monetary policy structure (already a clue). The consequence of that review was a new policy framework.

This is the part that central bankers hope (either that or they really, really believe you are really, really stupid) you never notice. I'll allow former Fed Chairman Ben Bernanke to summarize, as he wrote that day at his Brookings blog:

"Although the BOJ did not take substantial new easing measures, I think the announcements are good news overall, since they include a recommitment to the goal of ending deflation in Japan and the establishment of a new framework for pursuing that goal."

Why does the Bank of Japan need "a new framework" at all? It was merely three years ago that Kuroda promised exactly that in much the same words; meaning that without casting doubt about prior QE, he claimed that QQE starting in April 2013 would be a new framework to allow his central bank to further recommit to the goal of ending deflation. The size and addition of another "Q" were touted as exactly what Bernanke is advertising of yield curve targeting now. In fact, if you review the history of all these programs, a history that is tragically, perhaps criminally long now, you will see exactly these kinds of pronouncements preceding their inaugurations; a new framework that will "allow" inflation to happen as economists expect without any reference as to why the old "new framework" didn't "allow" it as economists expected. Central banking is now never having to say you're sorry.

In short, the commitment to inflation is present in each; it is the abilities that are by the nature of constantly changing experimentation questionable and rightly questioned. There is a world of difference between policymakers being granted carte blanche to try untested theories in order to discover the problem and the solutions to it because the world has no other choice; and economists presenting themselves as absolutely sure they know what they are doing and, better, sublimely confident that they can do it. We have been given the latter while living in the former; with one difference - there is a choice.

It doesn't take much study to notice in what direction all these "new frameworks" are heading. Under the Greenspan era of interest rate targeting there was nothing more than implicit promises about what might be done should conditions ever arise that would force "might" to become "needs." Nobody ever challenged the Fed because everyone assumed the Fed could not be challenged. Though the Fed loomed, it was strictly speaking a private matter. The federal funds market rate, therefore, was extremely well-behaved; so much so that the global marketplace for money transferred that behavior into a rigid hierarchy preserved across international and often currency boundaries.

Starting August 9, 2007, "might" was no longer operative; money markets demanded a response. What the Fed offered was initially just more of the same, meaning that though there was an emergency 50 bps cut in the federal funds target it didn't amount to anything tangible in money markets (LIBOR tended to remain high with federal funds low). And so realizing that "something" was very wrong, the Fed began to develop tools and a "new framework" to recommit to their goal of stable money, inflation, and employment.

Among the first of the new tools employed was dollar swaps dating back to December 2007. The initial swaps were $20 billion to the ECB and $4 billion to the Swiss National Bank. In the European version, the Eurosystem (not the ECB, but the NCB's) started by conducting two dollar auctions in connection with the terms of the Fed's Term Auction Facility (TAF) against ECB-eligible collateral for maturities of 28 and 35 days. European banks submitted bids for the funds, recognizing what used to be a central bank truth - you could target a rate or a quantity, but not both.

The esoteric framework belied the global nature of this "dollar" problem. In other words, the swap lines were a ruse; it was the political reality of the Fed finally being forced to confront the fact that the dollar wasn't limited to American experience or needs. Statutorily, however, they could not directly transact with European (Swiss or Japanese) banks (other than domestic subsidiaries of foreign banks already designated as primary dealers) so they used foreign central banks as the redistribution point for global "dollar" liquidity provided still by the Federal Reserve. These counterpart overseas central banks would shoulder the credit risk, but in reality there wasn't any.

But because these were necessary workarounds, the Fed was constrained by making its foreign swaps fixed by quantity. Because the quantity was invariant, the price couldn't be; that is why the ECB (and later other central banks) had to tender these dollars under an auction arrangement. Many banks were shut out unless they bid at increasingly penalized rates, and were often outbid by banks that were just hoarding liquidity even though they could more easily absorb the price.

There is perhaps a central bank equivalent to the Heisenberg Uncertainty Principle of quantum physics. Werner Heisenberg in 1927 stated that the more precisely an observer measures a particle's position, the less precise he would be about its momentum; and vice versa. In monetary economics, the more precisely a central bank defines the quantity, the less precisely it will be able to define the price; and vice versa. There are setbacks to this limitation, and it defines one reason why central bank function is not substitutable for market function. There is multi-dimensional depth to the latter and only rigidity in the former.

Obviously, if the "dollar" system had been functioning reasonably well in December 2007 neither the Fed's quantity or price would have much relevance. Thus, it is only under pressure that these mechanics apply. Quantitative easing may have empirically established this point better than anything else.

Since the world now suddenly requires a "new framework" because controlling the quantity of bank reserves was in all honesty an abject failure, some central bankers are attempting to address both price and quantity. The Bank of Japan's new focus is on the yield curve of JGB's, Japanese Government Bonds. After having disastrously upset money markets in Japan earlier this year with its prior "new framework" of NIRP, BoJ now contends to exert more control over the government bond curve itself.

Even in Ben Bernanke's blog post the former Fed Chair noticed the contradiction, writing, "In that regard, it was puzzling that the BOJ retained its 80-trillion-yen quantity target for JGB purchases; one of these two targets is redundant." The other target he was referring to was the price on the 10-year JGB. As it stands right now, the BoJ is targeting both price and quantity. The new policy statement may allow some softening as to the idea of what exactly is their target, meaning that there is some leeway as to the quantity of purchases. But in many ways, that is beside the point and certainly less important than what we are figuring here.

As I wrote above, where this is all heading is increasingly obvious. With every failure there is only greater control no matter how much it strains the logic of everything up to common sense. Because central banks never apologize, the only "choice" is a false one - more central banking. I have written before (many times) that they should just end the charade and listen to the inner totalitarian that is inside every single one of them - some may object to the characterization as totalitarian but frankly what other description applies? Stop targeting quantity or price, or quantity and price, and just command since central bankers have a view of what "should" be and will not let it go. The Japanese have edged closer to this reality than anyone else because they have been failing for far longer. And it is all failure.

At least at that point we can have an honest system, rather than this current one where the public isn't quite sure what central banks are. For the great multitude on the "left" who recognize their failure, the once vocal contingent of Sanders supporters, they count the Federal Reserve as if it was the heart of capitalism. It is the only success that can truly be counted for the institution, convincing people that it's command "type" policies were not just compatible but a necessary part of an ostensibly "free market" system. Removing all pretenses would at least abolish the lie.

From that position we could begin the work of actual restoration; not a new "framework" for further hidden authoritarian mandates, but recognizing all these distinctions and how they truly matter.

In September 2013, Bank of Japan board member Koji Ishida warned policymakers were growing concerned, even at that time so close to the start of QQE, that the goals of Abenomics "may be thwarted by the private sector." How dare it.

"Unless income rises in tandem with prices, economic growth will be temporary and not sustainable. Households' real purchasing power would decrease, causing consumer spending to decline and the whole economy to deteriorate. This would render meaningless our goal to exit deflation."

That is exactly what happened in Japan, a burst of harmful price changes that sent the Japanese economy spiraling into another mild recession from which it has yet to emerge - now "requiring" still another version of monetary experimentation with an even greater challenge to not just "exit deflation" but do so in the aftermath of the wreckage from the last one that started out making all the same promises.

Monetarily speaking, it wasn't money printing that "achieved" this inflation, either. It was simply the yen falling against the dollar more so on the myths of "money printing" than the reality of it - the same implicitness that once kept global money markets from disastrously fragmenting. To their great horror, Japanese officials have finally experienced a challenge to their commandments in the money itself; the yen which once dutifully obeyed and became "weaker" has since last year done only the opposite (the "dollar" once again demonstrates what truly matters).

Rather than realize that the market no longer believes in the myths because they are myths, central bankers seek instead to further command (read: destroy) markets for their disobedience (JGB's are tied directly to "dollars", yen, and NIRP). In this specific case, it is their own ignorance that is the basis for their call for more control - as is historically typical under authoritarian circumstances. Incompetence is often the catalyst for a tighter grip. They don't know anything about what is driving the yen really since the outbreak of "global turmoil" last year, while at the same time it is clear they don't appreciate inflation and its effects on an economy in anything more than an academic, mathematical sense of correlation.

Somehow that is supposed to add up to doing even more, not less. This includes the US Federal Reserve that though it may not seem to be doing more at the moment, by virtue of continuing to do nothing it is continuing what doesn't work.

What needs to happen is exceedingly simple; we must allow truly free markets or pull down the curtain and render unto full socialism. We cannot hide it any longer, and though there is much to legitimately fear over the latter I am still at this point confident enough that showing the full face of monetary socialism will be enough to finally tip the scales back toward the former (and sufficiently so) by first setting straight a great about what has been wrong all this time. History is not linear but cyclical, and the pendulum has swung very far in the direction of monetary socialism, a fact easily demonstrated just this week in both what one central bank did and what another did not. Maybe it does have to get darker before dawn, and in that sense Wednesday's policy decisions could be counted as progress in a world already driven upside down and backward.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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