You can’t say no one warned her. There were plenty of smart guys who tried to dissuade the Federal Reserve from hiking rates last December. Bridgewater’s Ray Dalio warned of a “1937 style mistake.” Doubleline’s Jeffey Gundlach made speech after speech about the economy’s inability to handle higher rates. Larry Summers even started a high profile blog to document the error he believed the Fed was committing.
Yet even with the warnings, Yellen succumbed to the “zero rate was supposed to be an emergency rate, and the emergency is long past” crowd. Or at least that’s what most market watchers believe. I am not sure whether Yellen’s dovish reputation is at all deserved (MacroTourist post for Dec 17/2015). She might be much more of a hawk than anyone ever imagined. Since taking over as head of the Federal Reserve, Yellen has steadfastly tightened monetary policy. She pales in comparison to good ‘ole Helicopter Ben.
Maybe you think a return to sane monetary policy is a good thing. I have no desire to convince you otherwise. For the past couple of decades I have railed against irresponsible monetary policies. Our economy is an utter mess. The Federal Reserve and all the other Central Banks have facilitated this transcendence into economic absurdity.
Where I differ from my conservative friends is my belief that it is way too late to return to prudent economic policies. There is simply too much debt for the economy to return to a normal state. The only way out of this mess is to have a massive reset.
Any sort of austerity or “proper monetary” policy would cause the economy to sink into a debt destroying vicious circle. Unfortunately the absolutely monster amount of debt means this normally natural economic cycle would be especially painful. And the oversized debt means government officials are loathe to allow this to happen. So instead of having a cleansing reset, we have just kept piling on more and more debt.
Which brings me back to Yellen and her desire to normalize policy. If she was willing to sit through a severe economic slowdown then I would be all for her tightening monetary policy. However we all know the moment things get ugly, she will return to the previous recipe of piling on even more debt.
A true economic reset through a massive debt destroying recession is not in the cards. Therefore the only other option left is for the governments to do what they have done for a millennia - inflate their way out of the problem.
I don’t like it, but let’s face it - we all know it is the final end game. The only question is timing.
For Yellen to pretend otherwise is only making the problem all the worse.
She can’t even hit her own targets
What’s especially amusing is the fact there is so much debt, the Federal Reserve can’t even hit their own inflation targets.
The Fed is using old metrics when they worry about inflation risk. They stare at the zero Fed Funds rate and fret inflation is about to take off. Meanwhile the simple truth is there is so much debt outstanding the old rules don’t apply. Developed nations have entered “balance sheet recessions.” Japan experienced the difficulties in escaping from this negative feedback loop, and it appears the United States refuses to learn any of the lessons from Japan’s lost decade.
Inflation has consistently been running below the Fed’s 2% target. If they truly have a 2% target, then half of the time it would be above the target level, and the other half below. Yet the past decade has been significantly below the target level.
As much as I hate to say this, have a look at Yellen’s two predecessors’ policy actions. Coming out of the DotCom bust, Greenspan did not raise rates until the PCE deflator hit the 2% target. And Bernanke actually took significant heat in 2012 when he allowed inflation to rise above the target level without raising rates. He correctly insisted the blip higher was transitional and refused to tighten policy.
Contrast that to Yellen who has raised rates with inflation running below 1.5%, the US dollar soaring and commodities plummeting. Some dove!
This morning as I write this Yellen has just released her Humphrey Hawkins testimony. The first paragraph says everything you need to know:
Since my appearance before this Committee last July, the economy has made further progress toward the Federal Reserve’s objective of maximum employment. And while inflation is expected to remain low in the near term, in part because of the further declines in energy prices, the Federal Open Market Committee (FOMC) expects that inflation will rise to its 2 percent objective over the medium term
Even though her policies are causing inflation expectations across all terms to sink, Yellen is confident she knows better than the market. In her mind, inflation is just around the corner. Even though the market is screaming deflation, her confidence remains unperturbed.
Have a look at the Fed’s favourite long term inflation gauge:
Yellen has consistently been way too tight for the market. The proof is in the pudding.
At this point you might be saying, “inflation isn’t a good thing, so why are you fussing?” And that is a valid argument. But if you take that line of reasoning, then you have to accept an economic slowdown that will result in a massive depression. The unprecedented amount of debt in the global financial system cannot be supported with falling inflation. As inflation falls, the real cost of the debt increases, which only encourages more spending cuts, which creates a self fulfilling deflationary death spiral. Remember - we need to either get inflation or deflation, there is no more happy medium ground.
Yellen believes she can thread the needle. But in doing so, she is causing the economy to tip over to the deflationary side. Failure to be anything but “responsibly irresponsible” as Paul McCulley so elegantly put it, will cause this whole dreadful science experiment to come a crashing end.
The Federal Reserve should remember there is no Mr. Wolf ready to help when they blow the brains out of the global financial system.
Thanks for reading,