The Fed Tries to Manage the Economy With Determined Ignorance

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Twice a year every year, the Chairman of the Federal Reserve drives up to Capitol Hill and formally reports to Congress. Given our current circumstances, these ceremonial affairs are lent a great deal of mainstream scrutiny as the public tries to parse the smallest scraps of unanticipated deviations from the carefully laid script. In many ways, this is a rerun of the late 1990's dot-com bubble, but in reverse. When Alan Greenspan would testify, even his briefcase would be subjected not to so much scrutiny but reverence for what the Fed would not have to do, as the St. Louis Fed embarrassingly confirms. When Janet Yellen testifies, the world waits with baited breath for her to endorse instead the smallest little something that the Fed might have got right.

This theatrical display of officialdom is but a remnant of much more substantial requirements of decades past. As is typical, historical periods of great upset are where hardened changes and reforms are born. People don't learn until they are forced to learn; bureaucracies most of all.

The reason Janet Yellen appears before Congress twice a year is the Great Inflation, the last period, for now, where it is universally recognized that monetary policy was a total disaster. Owing, ironically given where we are, to monetarists' damning critiques, in March 1975 both the House and Senate passed House Concurrent Resolution 133 that requested the FOMC set and maintain monetary targets. The Federal Reserve had already begun to do so, a year earlier, when it began to specify "ranges of targets" for both M1 and the relatively new and broader M2.

The relationship between money and inflation finally being set, it was crystallized by the Full Employment and Balanced Growth Act of 1978, that which we still know today as Humphrey-Hawkins. In a Senate hearing in 1976, Senator Hubert Humphrey remarked, "It is my judgment that the law has, from time to time, been conveniently ignored." The law to which he was referring was the Employment Act of 1946 that made it the responsibility of the federal government, and therefore by extension the central bank, to "promote maximum employment, production, and purchasing power" as if all that could be so managed.

Humphrey-Hawkins, then, was the legislative answer to the government problem of not being enough government such that the government could have "conveniently ignored" itself and allowed the devastating stagnation and inflation of that era to carry on for more than a decade and a half. To ensure it never happened again, the Act then required the unemployment rate of people 20 years and older to not exceed 3%, and that while inflation should be actively reduced from that time to less than 3%, by 1988, ten years forward, the rate should be zero. All of that was subject to the key statutory qualification that these legal requirements were only to apply should they not interfere with each other.

To achieve all of this, the Federal Reserve was to report to Congress twice a year in formal fashion beyond bland testimony but primarily its money and debt targets for four-quarter forward growth updated every quarter. This was all purposefully centered within a fuller discussion of economic conditions, since money and debt related to them, including inflation and unemployment, that survives to this day. The obligation to publicize and maintain money and debt targets, however, expired in 2000.

At the regular policy meeting of the Federal Open Market Committee on June 28, 2000, the second day of the gathering, then-Chairman Alan Greenspan recommended that they formally ditch the money and debt targets and even any references to them:

"As you know, this topic stems from the Humphrey-Hawkins legislation--a term we no longer use except in an historical context. Don proposed putting the long-run ranges for the monetary aggregates on the agenda as a placeholder. But it is my intention, if it is all right with everyone, to forgo both a discussion and vote on these ranges. We are no longer legally required to do that. The Committee, as you know, has not been using the ranges for the aggregates to guide policy for many years."

Formal Congressional updates to Humphrey-Hawkins were not at that time expected to include renewal of the target requirements, no doubt in full consultation with Alan Greenspan (no confirmation survives as to whether his briefcase was also asked by Congress to give expert advice) which is likely why he was so confident as to disdain any debate at all on the subject. The formal reasoning was, essentially, the late 1990's:

"Indeed, in recent years the ranges have become even more questionable benchmarks for money growth at price stability because of the uncertainties about long-run productivity growth and about what exactly we mean by price stability."

This is the key sentence not just applicable to the narrow question of money targets, but to everything that has followed including the very conduct of monetary policy itself and eventually its utter failure in what is now shaping up as a depression (meaning a more-than-temporary deviation of economic growth from underlying fundamental trends). Here we have the intersection of vast and unknown monetary changes in the real world combining with a period that in June 2000, so appropriate, looked to be a "new normal" of permanent prosperity. It was the height of both the so-called Great "Moderation" and the hubris that invented the term despite all the grave warnings and doubts that were only proliferating.

Mentioning specifically "long-run productivity growth", Greenspan confirms that he had no idea the dot-com bubble was, in fact, a bubble. The stock market had yet to surrender that news, though by the time of that FOMC discussion the NASDAQ had already worked in a little more than two months of repudiation. In monetary terms, if the late 1990's had indeed proven to be a new miracle of productivity, that would mean the economy could tolerate much more money and debt growth. The rules of Great Inflation, they clearly believed, no longer applied; a position policymakers had been moving toward, as Greenspan mentions, for many years by that point.

That view would imply, or at least how I have purposefully stated it, that Fed officials, especially Greenspan, had by the dot-com era figured "it" all out. We know full well that they didn't by the events that have unfolded in increasing pain and disaster the rest of the 21st century so far. Even by the cusp of the Great Financial Crisis, just weeks before the final, tortured break in the eurodollar system, none other than Janet Yellen was still referring to that myth of "long run productivity." At the May 2007 FOMC meeting, she recognized and admitted that productivity had clearly slowed during the 2000's (never saying outright the word "unexpected", but it was easily inferred) that might be a problem in the anticipated "slowdown" of 2008.

Then she went right back into full Greenspan:

"But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence-including a booming stock market, robust consumption, and rapid business investment-that was consistent with a hypothesis of a lasting increase in the rate of productivity growth."

The reason for her confidence, in general terms, was not that the Fed had figured out money but rather that the FOMC voted in June 2000 that they didn't any longer need to. This was the full implementation of "positive economics" that Milton Friedman had updated from John Neville Keynes. As Friedman wrote in 1953, paraphrasing, economists could legitimately justifying knowing very little so long as what little they did know explained a whole lot. The monetary argument of especially the whole 1990's broke down on those lines; meaning money was increasingly a fuzzier and fuzzier concept, but the track of the 1990's economy suggested that all policymakers needed was to focus on bigger aggregates and cursory indications - the very little that they believed would explain a lot, the economy.

This is not interpretation on my part. Alan Greenspan himself explicitly referred to these monetary changes on several high profile occasions, including the infamous "irrational exuberance" speech in the portion just before that specific utterance that people forget was his way of trying to almost rationalize it all. But he also made this point on money perfectly clear at that pivotal June 2000 FOMC meeting.

"This is not to say that money is not relevant for the economy. For a central bank to say money is irrelevant is the deepest form of sin that such an institution can commit.

"The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition."

Is it just coincidence that almost from the very moment that Greenspan uttered what is the most critical monetary statement of our time labor utilization in the United States suddenly ceased all its prior expansion? Literally, of course, yes, it is coincidence, but in figurative terms the representation is a perfect demarcation for how the world was about to run far off its track. It was the culmination of bad practices and theories about to be revealed, slowly at first, in just those terms. Back in April, I wrote about the more appropriate context for the US "recovery" since 2009 as it related to essentially modern money which economists have purposefully ignored to great, disastrous effect:

"Economists will argue that the US has been experiencing a recovery, and even a rapid one of late. According to the BLS, total hours worked do seem to point in that direction in the narrow view of an assumed business cycle. Through Q4 2015, total hours have increased by 12.8% since the trough of the Great Recession. The level that positive trend attained by the end of last year, however, is only 2% more than what the BLS estimates for the US economy at the peak (Q2 2000) just before the dot-com recession. In other words, there is barely more labor activity now at the end of 2015 than at the start of this century."

It is not just labor hours and measures of output that show this curious and suspicious deviation. Nominal disposal personal income had grown at just less than a 6% annual rate for all the 1980's and 1990's, seemingly to confirm Greenspan's non-specific money theory. From the middle of 2002 (thus, not including the dot-com recession in the calculation) to the start of the Great Recession, nominal DPI only managed 5.2%. That may not seem like a big difference, but over five years it really adds up. Since the trough of the Great Recession, however (thus, also not including the Great Recession itself), nominal DPI has grown by just 3.5%. The current estimate is $13.9 trillion when following that same nearly 6% rate as if the Great Recession were actually a recession would have meant more than $18 trillion by now.

Monetary policy, however, doesn't react to the BLS's version of total hours worked or nominal DPI (though it should), as Greenspan declared in his no-money treatise inflation is still a monetary phenomenon as Milton Friedman established long before him. Where everything that Alan Greenspan seemed to touch before those words of June 2000 seemed to go right, nothing has ever since. And that starts with inflation.

Just a few months prior, in February 2000 included within the last of the 1970's era components of the Humphrey-Hawkins report was a footnote reference to a change also in inflation methods. Just below what was the last official debt target range, 3% to 7% growth in non-financial public debt for the year 2000, the FOMC referenced its preference for the PCE Deflator over the CPI, primarily as a matter of flexibility in the calculation and revisions.

For the last few years of the 1990's, the PCE Deflator indicated that calculated, general consumer prices changes were consistently below target despite debt growth at the upper end of their established, statutorily-required target ranges (the data has since been revised to show that private non-financial debt at that time was well-above the upper bound 7% range). This was, they believed, the result of that new plateau of prosperity delivered by productivity. The economy seemed to tolerate stronger money and debt growth (again, much stronger) without generating inflation and forcing them to live up to the inflation "mandate" put in place in the 1978 Act.

This condition, however, didn't last long. In early 2000, measured inflation jumped above 3% and remained above target until the dot-com recession. During the recession and its immediate aftermath, the deflator showed a sharp, serious drop consistent to what economists believe and what we actually find in periods of economic depressiveness. By 2003, however, inflation was back up to and over the 2% target (another late 1990's evolution which would remain unofficial until January 2012) and by June 2004 the FOMC was confident enough to begin raising the non-specific monetary lever of the federal funds rate (non-specific because the FOMC believed that one rate would rule all rates, including offshore "dollars" as indicated by LIBOR).

In June 2004, the PCE Deflator indicated an annual inflation rate of 2.81% (these are the latest updated figures that are different than what was released and calculated contemporarily). Increasing the federal funds target 17 times over two years between then and June 2006, the "money" rate had been pushed up from just 1% to now 5.25%. In that month of the final rate hike, however, the PCE Deflator showed then 3.31% inflation. Worse, while inflation would drop sharply in October 2006, by the middle of 2007 (largely based on oil prices) inflation was rising again all the way into the middle of the Great Recession.

That left policymakers entirely confused, dealing with an oil surge pushing up inflation rates all over the world at the same time general and global illiquidity was spreading just as far and wide; to the extent that it had already claimed one of country's oldest and most respected investment banks even before the PCE Deflator peaked in July 2008 at above 4%.

But while Greenspan's "tightening" had so very little effect, the eurodollar's panic eventually did; so much so that, as I alluded to in the opening, conditions on this side of the rupture are an almost exact mirror. In reality, Greenspan's Fed actually did very little because they thought there was very little for them to do. What little they did do, as the rate hikes in the middle 2000's forewarned, proved to be irrelevant.

During those years of "rate hikes", non-traditional monetary formats exploded, defying any sense of "tightening." At the end of the second quarter of 2004, just when the first FOMC hike vote was taken, total federal funds and repo volume plus financial and asset-backed commercial paper, all monetary elements outside of any of the "M's", only partially and tangentially represented in M3, totaled just less than $4 trillion. As the federal funds target rate rose, the level of these wholesale money elements did too; dramatically. By the middle of 2006, the aggregate was $5.25 trillion, a monetary increase of 31%. At the peak just a year later, visible wholesale money growth would add another 11% to reach $6.2 trillion.

These are just balances that were calculated and available, and thus represent only a part of what the full eurodollar system provided unseen globally. I can and have recited the simultaneous and related explosion of dark leverage in the form of derivatives, especially credit default swaps and their also monetary properties, all in direct defiance to the so-called tightening regime of the middle 2000's. It's not hard to figure what inflation was following, and it wasn't the federal funds target.

Since then, however, every form of wholesale money has declined and not in a regular, even fashion but clumped and uneven in disruptive outbreaks; the "rising dollar" since June 2014 being the latest, a continuation of the trend re-established by the 2011 crisis. The first was, obviously, the panic and Great Recession itself. But as the lack of recovery and further monetary policy failures all over the world have proved, the Great Recession was never a recession. It was a test of monetary knowledge and proficiency, and unfortunately for the world economy and all its inhabitants the Federal Reserve, the one outfit charged by superseding law in the Federal Reserve Act of 1913 with safeguarding the dollar, had by June 2000 defaulted on all competencies to and about it.

No matter what the Fed does, or any global central bank, inflation only decelerates now. It has been 50 months and still counting since the PCE Deflator was at the Fed's now explicit inflation target of 2%. And oil prices figure prominently again, though not as some excuse to dismiss the number, but as a shining beacon of the wholesale money framework where the modern "dollar" is at its center. Of the past nineteen months, the Fed's preferred inflation measure has suggested general price changes of less than 1% in eighteen of them, including, "unexpectedly", the last five.

This despite trillions upon trillions in "stimulus" offered primarily through QE's that vastly swelled the global count of "bank reserves", including in dollars, as if they were all monetarily germane. The people sense instead, as in the 1970's, grave monetary mistakes. Economists are stumped, and even lashing out at the public for even thinking it. The media refuses to report it. Politicians, mostly, run away from it. Yet, it is all right there in the public record.

Most people especially in positions of influence cannot move themselves beyond the inappropriate love affair with Greenspan's briefcase largely because it represented the pinnacle of technocratic idealism. As Ben Bernanke said in July 2013:

"In general, the Federal Reserve's policy framework inherits many of the elements put in place during the Great Moderation. These features include the emphasis on preserving the Fed's inflation credibility, which is critical for anchoring inflation expectations, and a balanced approach in pursuing both parts of the Fed's dual mandate in the medium term."

He was absolutely right, though in no way the manner in which he suggested, meaning the technocracy was thoroughly corrupt the whole time (can it be a technocracy when you are in all ways technically deficient and willfully so?). The implementation of QE was done off the myth of the Great "Moderation" as if that economy were all the work of Greenspan productivity magic. The problem of QE, the one that the PCE Deflator has reconciled on both sides of the Great Recession (that, again, was not a recession), is that it so thoroughly disproved the fairytale. The Fed intentionally stopped figuring money, and now it has no monetary abilities. Markets, especially bond and funding markets, now know it. That is why rates have fallen especially under the "rising dollar" that has only further confirmed all this, bleeding into oil and commodity prices and now once more calculated inflation.

Inflation is a monetary phenomenon, and central banks have none of it. Though monetary aggregates had indeed been outdated by technological innovation in finance, obliging the FOMC to carry on the exercise of producing money targets anyway would at least have shown it. At worst, it might have meant forcing the Fed to come up with suitable, workable alternatives through actual investigation into this brave new world (that by then was no longer new) of modern money just to try to live up to their legend (and likely exposing it for what it was).

Instead, as if to emphasize every bit of this deficiency, they discontinued M3 at the worst possible time, not that M3 was accurate or immediately useful but in symbolically ending all hope of any serious inquiry of its subject matter just when it was about to be needed the most. Maybe the next Humphrey-Hawkins that surely waits at whatever will be the end of this lengthy disaster will require first an admission that trying to manage the world economy through determined ignorance was, and sadly remains, a thoroughly dumb, maybe even illegal, idea.

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

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