Janet Yellen Uses Fed Failures to Expand the Fed's Mandate
Janet Yellen has been in the spotlight for much of this past week, only perhaps removed one step from the brightest center by events yesterday in the Ukraine. On an economic whirlwind, her goal over the past few months has been to convince anyone and everyone that the economy has nearly healed, the trajectory thus brightened enough to allow the Fed to gracefully exit and take full credit for it. While that is certainly the broad stroke of what looks to be "forward guidance", for now, there is more than a little complication between here and there - without even factoring the here and now.
The idea of taper continues to be publicly asserted as driven by economic conditions. That's somewhat difficult to accept on its face as clearly growth has decelerated ever since E3 was forced back upon "markets." In the six quarters prior to the initiation of this latest manipulation, GDP averaged 2.9% (seasonally-adjusted annual rate); itself unsatisfying by every historical comparison. In the six quarters since, including the disaster in the first quarter that we are supposed to just ignore, GDP has averaged only 1.3%. That has set about a "strange" dichotomy whereby we see clear and broad economic deceleration (and it's not just GDP, almost every economic factor is included here) set against an unmistakable drop in the unemployment rate.
The Fed under then-Chairman Bernanke was particularly distinct in pegging monetary intrusion to the labor market. But almost right away there was a problem in doing so, as the unemployment rate fell faster than anticipated. What should have been universally cheered as fast action and response was instead derided as decaying labor participation, and thus the denominator in the unemployment fraction, as contradictorily the driving force. It was so much so that even the FOMC acknowledged the circumstantial insufficiency of the statistic and violated its own soft "rule" about using it for monetary calibration. It was the first instance in history where the labor market was proclaimed to be healing by significantly less proportional labor.
In that sense, the labor degeneration actually confirms the reading in GDP in that genuine acceleration in the economy would produce quite the opposite effect on the unemployment rate. Thus the first quarter's reading was more than a little problematic toward Yellen's preferred narrative of nimble and unambiguous normalization.
In April, she spoke directly to this preferred pathway, especially in the age of drastic balance sheet size and uncertainty about how to get away from it.
"Fundamental to modern thinking on central banking is the idea that monetary policy is more effective when the public better understands and anticipates how the central bank will respond to evolving economic conditions. Specifically, it is important for the central bank to make clear how it will adjust its policy stance in response to unforeseen economic developments in a manner that reduces or blunts potentially harmful consequences. If the public understands and expects policymakers to behave in this systematically stabilizing manner, it will tend to respond less to such developments. Monetary policy will thus have an "automatic stabilizer" effect that operates through private-sector expectations."
Again, this is a form of rational expectations theory premised upon the acceptance of monetary stewardship without reservation. It sounds so very simple and easy, as in the public simply entrusts the wisest economists at the FOMC to do what is absolutely correct at the absolutely correct time. Once such credibility has been established, the public can largely ignore any bumps in the road since it will be reasonably assumed as already handled ahead of events. In more recent weeks, Chairman Yellen has been speaking about "resiliency", in that policy measures to this point have built up margins for error in order to withstand such "unexpected" shocks.
In order for that to even begin to take place, however, there needs to be some accounting for 2008. If you go back and actually take a look at policy stances prior to the "event" you will see exactly the same set of policy expectations and expected responses to policy settings. In other words, Greenspan's Fed believed that the public had entrusted itself entirely to the Fed in the wake of his "successful" handling of the dot-com bubble via the housing bubble. In the inner workings of domestic monetarism, that afforded enough credibility, in their minds, to roll out the same idea of "resiliency" in the mid-2000's.
Of course, as it turns out, the FOMC was always at least one step behind, not the least of which was due to their inability to evolve with finance. They were using 20th century techniques on a 21st century system that was breaking apart at breathtaking speed. To say that the Federal Reserve System, with its ages-old "birthright" to currency elasticity, was incapable of actually handling not resiliency but shocking fragility is an extreme understatement. That is why they had to reach beyond the textbooks, beyond, in some cases, legal certainties and into the extreme experimental - and mostly after the fact.
The current stance with regard to resiliency is simply that they have learned their lessons from the past seven years, and have thus retooled sufficiently to have actually earned such trust. Yet, for all that has been supposedly gleaned from such existential failure, there persists more than a few nagging doubts about this claim as to what is really entitlement (or monopoly). That starts, of course, with the inability of monetary policy under "emergency" conditions to actually deliver as promised in the economy.
Ever since the BLS's count of payrolls reset at the previous cycle peak, setting aside any argument of validity and labor force discontinuity, there has been a tendency to use that as a "mission accomplished" waypoint. In that same April speech, Yellen previewed exactly that:
"Nearly five years into the expansion that began after the financial crisis and the Great Recession, the recovery has come a long way. More than 8 million jobs have been added to nonfarm payrolls since 2009, almost the same number lost as a result of the recession. Led by a resurgent auto industry, manufacturing output has also nearly returned to its pre-recession peak."
She was being overly charitable to the point of being disingenuous. To take more than five years (it was actually 76 months from the January 2008 payroll peak to its revisit in 2014) and still be so far behind is inexcusable, though that has been the newest facet of monetarism these days. The only prior historical comparison where manufacturing has remained below its prior peak for so long in a dislocation was the Great Depression. And the raw job count that has been re-attained is not exactly that in terms of quality - full-time jobs (as of the BLS's latest figuring) in June 2014 were estimated at 118.2 million, still 3.7 million less than November 2007!
These are not figures to be proud of, used as "evidence" for clear confidence in forward policy operational exigencies; this is nothing short of a failure being cloaked intentionally in reduced standards. When Ben Bernanke initiated the primary debasement in November 2010, he did not proclaim that it was the intent to engage in another "created or saved" jobs count, as in the primary job of QE was rather to not let the economy grow worse. Yet, that is exactly what is taking place now as QE is being re-assessed in light of actual circumstances that, again, do not conform.
At the latest FOMC meeting earlier in July, the Wall Street Journal's Jon Hilsenrath summarized the redesigned conjecture about "emergency stimulus" as just that:
"Critics have long argued the program risks causing another financial bubble or excessive inflation, without giving an obvious boost to hiring. Fed officials and other supporters of the program argue it has helped the economy grow faster than it would otherwise grow, with limited risk."
Again, there is an incongruence here that is begrudgingly working its way into even the supporters' collective admission; namely that none of it worked the way it was supposed and proclaimed to. That is why it is increasingly difficult to take monetarists at their word that everything is now under full control, because nothing has gone to plan really going back to the turn of the century.
As much as I think that should be enough to discredit the entire philosophy, a full examination of Yellen's statement reveals something even more unusual and troubling. What she is arguing for is power over monetary affairs, and thus the economy, that are even more surreptitious than anything we see now. It is cleverly crafted, hidden in innocuousness that isn't revealed upon anything other than close reading. To repeat what she said (this time only what I think is the real intent):
"...it is important for the central bank to make clear how it will adjust its policy stance in response to unforeseen economic developments in a manner that reduces or blunts potentially harmful consequences. If the public understands and expects policymakers to behave in this systematically stabilizing manner, it will tend to respond less to such developments."
She is actually advocating reduced vigilance on the part of the private sector - that the monetary framework as it stands now has surpassed some unknown standard whereby the public "will tend to respond less to such developments." That is really a frightening assertion, not the least of which is because it amounts to a total rebuke of the placement of true markets as primary economic and financial tools. What she is saying is that markets are inherently "wrong" about negative "events" and that the Fed will be there, whenever and wherever, to take up the anomaly and see it to harmless conclusion. What is the role of markets under such a paradigm, to only follow the preferred trajectory set forth via diktat and central decree?
The axis upon which the whole idea turns is "potentially harmful consequences" by which Chairman Yellen softly and deftly alludes to something like "precrime." The FOMC will determine which "market" events are distasteful to central expectations and take such action as thought warranted, without any possibility of admonition or contrary opinion, to bring about nothing short of centralized goals. Once that pattern becomes entrenched, the scope of such unapproved activity will only widen, and the narrowness with which markets are "allowed" to operate will intensify - look to the ECB, or better yet, the Bank of Japan to see this future place.
That is not resiliency, it is outright surrender through wilful consent of appropriation. What is waiting there is even more sclerosis and dysfunction than we have now. As in all things bureaucratic, failure is used as an excuse to widen the reach of centralized authority. The Bank of Japan, not seeing its tenth episode of QE defile the nation enough to its liking, condescendingly blaming the country itself for not following the monetary genius set forth by its planning regime, has now resorted to outright purchase of equities. Are the Japanese to next see an actual stock index target as part of monetary policy, if only in practice rather than public proclamation?
In short, there is no end to the lengths that will be undertaken once starting down Yellen's path of collectivization. And given the inevitable failure of it, as it always ends in as much in disappointment if not disaster, will be used as the ratchet for the next pogrom of stamping out of free opinion. No amount of central authority, contrary to all the colorful mainstream assertions, can act in a manner which will consistently create that which they seek to foster.
The very process of centralization is itself the problem, as I wrote last week about the difference between modern statistics and the real world. Markets can incorporate all the "jagged edges", information that is vital not random, that are beyond the capability of even the most sophisticated regression mathematics. You can even add some non-linear theory to it and it still won't be enough to process meaningfully everything that a market can absorb and implement efficiently.
We don't need to stay within the realm of theory in which to prove that point. Twice now, the Fed's master plans have been rebuffed by what is nothing more than typical and natural variability in a complex system. In October 2008, the FOMC announced that it would create a floor under short-term interest rates by paying interest on both reserves and excess reserves (IOER). There was little by way of reservation about the process, as it was intended to, "...help to establish a lower bound on the federal funds rate." It failed right from the outset, or as I described it last year:
"It has never worked as intended, though it remains to this day. The effective federal funds rate has never traded above the IOR rate once it was set to 25 basis points. What was supposed to be a rate floor akin to European operations has instead been a very durable rate ceiling."
That's a pretty big miss to theory, as a rate "floor" is not a trivial feature of monetary policy. Yellen wants markets to ignore potential indications of disaster, but uncommonly low or negative interest rates are a direct signal of liquidity distress. The Fed also did what Yellen mentions now, namely carried out what it believed was a "credible" policy to address this distress, only to see it completely fall apart.
But in this new 2014 paradigm, we are led, again, to believe that lessons have been learned and new theories have brought into the "toolkit" to broaden their reach. The Open Market Desk has developed and tested a reverse repo program designed to address exactly this deficiency - once again trying to enforce a floor on interbank rates. The reverse repo program allows non-banks that are ineligible by statute from gaining the IOER to take an alternative, thereby, in theory, creating sufficient central bank coverage to maintain that desired floor.
The other major function of the reverse repo program, as it relates to exactly interbank effectivity, was to act as a sort of shock absorber upon any collateral shortage. As much as conventional wisdom sees the panic in 2008 as a banking affair, it was really a repo episode whereby cash and funding markets were reacting, dysfunctionally, to collateral problems. The shortage of usable and available collateral severely and persistently "violated" the rate floor, as nearly every US treasury security went special and t-bill rates flirted with durably negative yields. It was hard to see "normalcy" and faith in the Fed while these markets persisted in panic and disorder at precisely the same time all these "emergency" programs were designed to foster otherwise.
So it has to be more than a little unnerving to the current FOMC to see, yet again, its rate floor violated in such public fashion. Despite the reverse repo program, with its assumed emergency store and inventory of US treasury collateral, the central system has failed to calm repo markets stressed by nothing more than quarterly window dressing (that is simplifying it somewhat, but the main idea stands). While general and published short-term rates have not been disturbed by this latest fiasco, that does not mean what many think it means.
There was a surge in repo failures beginning in the middle of June, the most since the dramatic illiquidity in 2011 and 2009, that, if actually incorporated into a comprehensive and singular representation of repo rates, would have been negative, "violating" once more the rate floor and making a mockery of FOMC claims to reverse repo efficacy. Since the fails penalty is set at 3%, the $400 billion in fails (cumulative of both "to receive" and "to deliver") meant that much repo effectively was trading at -3%. And that does not count the numerous and heavy persistence of securities trading special at rates well-below (and negative) those published "representations."
To this Janet Yellen and her band of central planners would have us simply ignore it, especially where their brand-new policy, theoretically updated for the times, failed so spectacularly under relatively benign conditions. And that is where this gets particularly tricky, because if you extrapolate her intentions, she would have us ignore it again under even more significant strain. I used the analogy this week that this was akin to having some hard chest pains and the doctor proclaiming "nothing to see" despite the evident appearance of both very high blood pressure and cholesterol.
Whether economic expectations or financial function, there is so very little by which to accept the premise that the Fed can live up to what is really its own variety of narcissism. I suppose that is common to all authoritative systems, but it is especially vexing, and even dangerous, when that is accompanied by a now-outward disdaining of free markets and their relevant place in the economic hierarchy. They are essentially saying that they will carefully and effectively redistribute assets and "money" within the economy and do so in a manner that will finally succeed (after clearly failing for so long) without any significant downside (or at least none that us laymen should concern ourselves about).
Empirically, this is all just nonsense amounting to wishful thinking. Every authoritarian craves a world that will simply bow to command, but that never happens. Saying that you can handle the inevitable bumps in the road, even minor ones, is far different than actually doing it. And there hasn't been a lot of doing recently, though that isn't stopping the pace of economic reorientation. Only heightened and very much justified disbelief will do so, channeled effectively into actual reform toward capitalism and free markets.