How will we devise a master plan to resolve our economic woes? One way is to engage in repetition and hope for a different result. Not long ago, Nobel prize winner Paul Krugman opined that the Fed is "reckless for refusing to pursue higher inflation."
"We have had a massive failure of our political system that has come to accept that 8% unemployment is the new normal and there is nothing that can be done," Krugman said. "We're in a low-key version of the Great Depression."
Krugman, whom Bernanke hired at Princeton in 2000 when he was chairman of the economics department, has said the Fed should tolerate inflation of 3% to 4% to boost the economy and put Americans back to work. He was responding yesterday to Bernanke's comments last week that pursuing such a policy would be "reckless."
The interesting fact, and academically inconvenient, is that the Fed is already guilty of recklessness, according to any run of the mill Economics textbook, and expanded its balance sheet "from $869 billion on August 8, 2007, to well over $2 trillion," according to the chart below from the Federal Reserve, although it should read "to almost $3 trillion."
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Let's pause. A record high Fed balance sheet combined with record low interest rates is equivalent to Mr. Bernanke working to keep inflation below 2%? I fail to see the logic. What exactly is the Fed to do? It's not as if the Fed can mandate people to borrow and spend in lieu of a penalty.
It is customary now to release the "Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents" after every FMOC meeting, and the table below is the recent summary (pdf).
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The official appearance of the projections is impressive, and I certainly agree that forecasting is a daunting task. But the numbers assume a gradual economic improvement in varying degrees without a palpable logical foundation. Furthermore, there's no allowance for adverse outcomes, and straight line economic theory prevails, although a footnote does indicate that "further shocks to the economy" are not discounted.
Then there's the 30-year mortgage rate, or the bread and butter of the housing industry, and the record low rate of 3.66% last week should be a stimulus to any willing buyer. After all, banks do need a 3% spread to operate, or so I've been told, and we're approaching the bottom. Where to from here?
The deflationary case has been made repeatedly for over one year, and the Fed's goal of diffusing the inevitable continues to lose ground. With West Texas Intermediate and Brent oil future contracts dropping close to 20% and 15% respectively since the beginning of the year, we shall see where inflation will be in the months ahead. Certainly energy is not part of the core CPI reading, but it's embedded into everything we buy. Thus, energy is part of the core CPI. One key question is whether the savings the consumer is realizing from lower gasoline prices will be redirected into other economic sectors. Maybe. But maybe the pervasive negative consumer sentiment will prod citizens to take the opportunity to save for a rainier day.
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Japan has played the economic stimulus game nonstop since the bubble burst in 1989, and after more than two decades, the "free" money has led nowhere. Yet, many pundits state that we're not Japan, much like housing in China is different from the subprime mess, until it isn't. A Bloomberg article summarized the Japanese predicament quite well, and it's not theory. It's a measurable fact.
After flooding the banking system with cash from 2001 to 2006, the central bank now has deployed its second round of quantitative easing. The moves haven't ignited growth, with GDP rising at an average rate of 0.75% in the past 20 years, according to International Monetary Fund data. Consumer prices fell in eight of the past 13 years, and inflation hasn't exceeded 1% since 1997. Unadjusted for price changes, the size of the economy last year was the smallest since 1990 and had contracted 10% from its peak in 1997.
Over one year ago I suggested that monetary policy was wrong because the game is not about economics and innocuous Federal funds rates, something the average person does not care about or understands. Our good citizens are driven by their surroundings, personal wealth, and a perception of the future which is largely molded by the news media. Then they act accordingly.
The recent quarterly consumer sentiment reading by Nielsen showed that pessimism prevails, but the emphasis must be placed on the ongoing perception, or personal reality, of a recession, which we know to be erroneous based on official data.
Seventy eight percent of Americans believed the economy was in recession in the three months through June. That was down from 83% in the previous survey but 56% of those who saw a recession in the latest survey expected the downturn to last at least another 12 months.
This is a psychological game, and that is why despite low rates and plenty of money printed, consumer sentiment is still negative. Back then plenty of readers stated that I was crazy for suggesting that rates should be increased, not reduced, but insanity, as defined by Einstein, is doing the same thing over and over and expecting different results.
Using GDP as the foundation, which has been positive for over two years, the Fed should have increased rates to 1% by now, and the consumer would have responded in kind, because the message would have been that the economy is improving. As it stands, the perpetual narrative is that we're not there yet, and it may get worse. Why spend beyond necessity when the "experts" don't see the light at the end of tunnel?
Certainly there are plenty of other factors that we're aware of, such as fiscal policy, but unless the consumer acquires a good perception of the future, any monetary gimmick that can be devised will fall flat on its face. Money supply expansion to eternity will never address consumer sentiment, and that human, hard to grasp, variable is not covered or understood by any economic theory.
The Bank for International Settlements delivered an opinion about the power of monetary policy, while faulting fiscal policy.
"Central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed," the Basel, Switzerland-based BIS said in its annual report, published yesterday. "Both conventionally and unconventionally accommodative monetary policies are palliatives and have their limits."
Palliative? That means "to ease symptoms without curing the underlying disease; to cover by excuses and apologies." Ouch! Billy Ray Valentine would be better qualified to offer economic opinions, because he understood pork bellies, people, and consumption patterns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
