Friday's Market Plunge Shows Us What's Wrong With the Fed
The financial markets' violent reaction reacted to Friday's "Employment Situation" report from the Bureau of Labor Statistics (BLS) highlighted everything that is wrong with the Federal Reserve's discretionary, "no rules" monetary policy. If the Fed were following a monetary rule that simply required them to keep the real value of the dollar stable (e.g., by keeping the CRB Index* constant), the markets would have had no reaction to the BLS report at all.
Government agencies can only report on the past. For example, Friday's "Employment Situation" report represented the BLS' best effort to describe labor market conditions as of mid-February. The financial markets operate in real time, and they process price signals, which communicate everything that matters economically about everything going on in the world. This includes how many people in the U.S. have jobs, what kinds of jobs they have, and what they are being paid.
Accordingly, the closing prices of equities, bonds, and commodities on Thursday, March 5, already reflected actual labor market conditions, not just as of three weeks earlier, but all the way up to the closing bell. So, why would a government report on the job environment in mid-February cause the Dow to dive by 1.54%, interest rates on 10-year Treasuries to soar by 6.17%, and the price of gold to plunge by 1.47% on Friday, March 6?
Answer: In the markets' judgment, the BLS report raised the probability that the "experts" at the Fed will use their discretionary power over money to do something economically destructive. But what?
Before we delve into the markets' (fully justified) fears about the Fed, let's look at the BLS report itself. Many pundits declared it to be wonderful, but it was actually mixed at best. It certainly did not provide evidence that the jobs market is "overheating." And, in any case, an overheating labor market is not something that can occur with free markets supported by accurate monetary control. "Overheating" is only possible with an activist Federal Open Market Committee (FOMC) that is in the grip of the "Phillips Curve" superstition, which is the erroneous belief that there is an unavoidable tradeoff between inflation and unemployment.
Analysts fixated on the reported 295,000 rise in payroll employment, which was considerably higher than the consensus was expecting. However, this number comes from the "Establishment Survey," which includes a lot of jobs that are assumed into existence via the BLS' "Birth/Death Model." The BLS' "Household Survey" numbers did not support the notion that happy days are here again.
According to the BLS "Household Survey," total employment increased by only 96,000 during February. The rest of the 274,000 reduction in unemployment was the result of 178,000 working-age people dropping out of the labor force. This brought labor force participation (LFP) back down to 62.83%, which was the level of June 2014-and only slightly above that of November 1977.
Although the expansion of welfare state alternatives to working under President Obama (e.g., Social Security Disability, Food Stamps, student loans that you don't have to repay) accounts for some of the reduction in LFP, there is no way that LFP would be this low right now if the job market were actually strong.
As has been the case throughout the current economic recovery, the reported drop in the unemployment rate (from 5.7% to 5.5%) was entirely an artifact of falling LFP. Adjusted to the LFP that obtained when Bush 43 left office, the unemployment rate did not decline at all during February. It remained stuck at 9.8%, which is only 1.7 percentage points below its 11.5% peak, in July 2011.
Looked at in terms of FTE* jobs, the labor market improved slightly last month, with the nation moving 71,000 FTE jobs closer to full employment. However, at February's rate, it would take us more than 16 years to get there.
So, Friday's "Employment Situation" report filled the financial markets with the fear of the Fed. But fear that the Fed would do what?
The conventional wisdom seems to be that the markets are afraid that "the Fed will raise interest rates too soon, and/or too much." This is not exactly true, but it can serve as an entry point for an explanation of what the markets' real fears are.
First of all, listening to the FOMC talking about raising or lowering interest rates is itself frightening. It should engender much the same feelings as would listening to doctors talk about bleeding patients. The Fed should not be concerned with interest rates at all. Interest rates should be set by the market; that is, by the suppliers and employers of various forms of capital (i.e., savings; real resources).
The Fed cannot supply real resources to the economy, and therefore should have no role in setting the price of capital. However, the economy needs the Fed to keep the real value of the dollar stable, in order to avoid distorting price signals and thereby causing malinvestment.
It is pretty clear that the Fed believes that its job extends far beyond merely keeping the value of the dollar stable. The Fed seems to have taken on the responsibility for managing the economy in general, and the presumed trade-off between inflation and unemployment in particular. It is also clear that the Fed believes that their Fed Funds target is their most important instrument for doing this.
This is all scary stuff. Central planning and management by "experts" of something as complex as the U.S. economy is an invitation to disaster. And, to rely upon economic statistics (including inflation and unemployment rates) to make decisions is like driving on a winding road while looking in the rearview mirror.
It's scary that the Fed does not seemed to have noticed that real growth, inflation, interest rates, and commodity prices have gyrated wildly during the 6+ years that it has kept its Fed Funds rate target constant at 0.00 - 0.25%. It is also frightening that the Fed did not seem to recognize that its QE2 and QE3 bond-buying binges produced the exact opposite results of what the Fed expected and intended.
The Fed obviously thinks that higher interest rates mean "tighter" (i.e., more valuable) money. They don't. In fact, they don't mean anything regarding the value of the dollar, so the fact that the Fed thinks that they do is scary.
Friday's "Employment Situation" increased the perceived probability that the Fed will try to "do something" soon to "tighten money." This is frightening to the markets, because the real value of the dollar against the CRB index has risen by 40% since the end of June, during which time the Fed was "doing nothing." The markets, which crave a stable, constant dollar, are justly afraid of what could happen if the Fed ignores the alarm bells going off in the commodity markets, and "does something."
Yet another reason that the markets are fearful about the prospect of the Fed "raising the Fed Funds rate" is that they know that there is no such thing as "raising the Fed Funds rate." The Fed Funds rate is a price, and prices are effects, not causes.
The markets know that, with $2.4 trillion in excess reserves in the banking system, the Fed is in uncharted waters. Under current circumstances, the method (Open Market operations) that the Fed employed for decades to manage the Fed Funds rate will not work, and the markets are justly afraid of the possible side effects of more Fed "improvising."
Summing up: 1) it is understandable that the markets would believe that Friday's BLS report increased the likelihood that the Fed would "do something" in the near future; 2) the markets have good reason to fear the Fed's rules-free improvising; and, so, 3) it makes sense that stocks, bonds, and commodities would plunge on the news.
To have a stable economy and stable financial markets, we need a stable dollar. The Fed cannot produce this via activist tinkering. If we are to have prosperity, the Fed must adopt a rule (ideally, one calling for a stable CRB Index) and stick to it.
*The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.
**FTE (full-time-equivalent) jobs = full-time jobs + 0.5 part-time jobs