Fed Policy Shifts Gears... What's Next?

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by: Robert Brusca


Why the Fed has shifted gears.

Structural stagnation or not?

Fixable problems: What Janet Yellen won’t tell you.

The Fed met just a handful of days ago. Now Janet Yellen is engaged in her second round of monetary policy testimonies before the two Congressional oversight committees. What more can we learn beyond what she said in the recent FOMC meeting?

The political agenda dings the Fed

What is clear is that the politicians have election-year agendas - we can learn what they are. And what we see from the questions that they are asking of the Fed Chair is the pressures they wish to bring to bear on the Fed - a favorite whipping boy.

Democrats went after Yellen on the issue of diversity. The Fed has women well represented but it does not have people of color very well represented in key voting positions.

Republicans are chaffing about the pressure of regulation and how it is affecting small banks. But Democrats are vigilant on the idea of regulation. Elizabeth Warren wants to make sure that the Fed holds large banks' feet to the fire especially on the issue of having a living will. The 'living will' refers to banks having a workable program to resolve (liquidate) themselves in the event they get into financial difficulties. They are meant to avoid a Lehman Bros repeat.

Beyond these particular points of interest the Fed continues to be pressured in various ways. Senator Shelby raked Yellen over the coals for the Fed's on again off again plan to hike rates with some vigor in 2016. He followed that up with a post testimony interview in which he warned the Fed to be careful with the fragile economy. It seems that the Fed is not the only one that cannot make up its mind. Some in Congress distrust the Fed so much they want policy on an automatic rate-setting rule. But ruling out discretion has risks.

What does Yellen really see?

Yellen's switch to warning on the economy after being on the multiple rate hike bandwagon may catch many off guard. On one hand she warns of slow growth, while on the other she all but dismisses the risk of recession (as to the latter, what else could she say?). This combination is going to keep the presidential candidates very busy. What better food for politics than an admitted too-slow growing economy? It helped to get Bill Clinton elected and killed the incumbent George Bush.

We already see various Senators asking, what can they do? Is fiscal policy a proper tool? Is the Fed ineffective because monetary and fiscal policies are not 'working together?' These are to some extent honest questions but they are also loaded as politicians try to get the Fed Chair to recommend the policy they want to support.

The Fed is on a hotter spot with only its less preferred tools left to use and an economy that is not performing as the Fed had expected. Of course, Yellen tries to put a brave face on it and professes to see an end to the sluggishness but… 'Does she really' or is that obligatory bravado?

We hear Janet Yellen speaking of headwinds and sounding more like Larry Summers whose views on structural stagnation she had all but dismissed. The Fed's tact since December has been to talk of the constraints on the economy as being 'temporary' such as from oil market disruption or from a too-strong dollar, but now the Fed's tune has changed.

What we have not gotten from this testimony is any notion as to why the Fed changed its mind. It is curious that in the wake of one poor job report the Fed is on a different page for policy and at the same time warning everyone not to take any single economic report too much to heart. Does the Fed listen to its own advice? This sort of behavior is maddening.

We cannot really have a plan to right the economy without identifying what's wrong with it. But Yellen dropped no clues about why growth is so slow or what the catalyst will be for growth to pick up.

Structural stagnation or not?

I was not a fan of the Feds' assertion that the economy's problems were temporary or a fan of the Fed having prepared a sequence of rate hikes for 2016. But neither did I think that we had structural stagnation. What we have is a bad policy mix. To me structural stagnation refers to something that is not fixable quickly and might require some extraordinary government action to offset an entrenched private sector problem. After all, the one duty of government we should all agree on is to provide a system of laws, a flexible financial system and a regulatory environment in which the economy can flourish. This economy has been sputtering under the hand of both parties. It has not run a current account surplus since the early 1980s. That's a 35 year period. Is that a good environment? What does that say about US competitiveness? What does it say about our leaders' economic knowledge?

Fixable problems: What Janet Yellen won't tell you

If you want a symptom of a problem that needs to be fixed, exhibit number one is the too-strong dollar as it makes (1) US labor too expensive on world markets (2) It wards off investment because it makes the US an expensive place to do business (3) it makes US exports too expensive (4) it makes US imports too cheap (5) it causes a drain of income and wealth to occur and, (6) its cheap imports encourage over-consumption. Many of the US low growth and productivity-reducing symptoms can be understood by reference to what a too-strong dollar does. Yet, no one has fixing that as a proposal - NO ONE! Donald Trump comes closest and people fear his approach. Instead, we hear talk of how 'more trade is better.' But more trade is better only if it is on a platform of free trade with market-determined exchange rates. Ours isn't. Somebody's education has been muddled.

Exports plus imports are 30% of GDP. International capital flows exert another enormous influence on our economy. In addition US firms juggle their investment dollars between the US and their overseas offices. Too often what we are left with are the crumbs of investment for the service sector because it is the last game in town and services are local and the competition is mostly domestic. As we funnel workers into that sector of last resort we develop more low-skill low-productivity jobs. We create the very conundrum that policy has not successfully confronted: the slow growth economy with 'fast' job growth. But since it is low skill job growth it is not very robust… the upside is limited, productivity gains are low. By stimulating services our trade deficit widens since services are so much less tradable. Service sector workers do not create exports but they do absorb imports.

Labor market illusions

At the same time we have our economic illusions to deal with. The proportion of the labor force with a BA-degree or higher is 39% today compared to 26% in 1992. Yet, we find that the Beveridge Curve has shifted out. That curve sketches a relationship between job openings and the unemployment rate and its shift tells us that we need more job openings today to lower our rate of unemployment than in the past. The paradox is that our labor market appears to be more skilled (educated, at least) but we are in fact lacking skills in many areas. Job openings go unfilled. We have the wrong skills and some have paid dearly to acquire them.

Beveridge Curve

One if by land two if by…visa?

Labor market signaling can correct that. Let wages rise for professions where skills are in short supply instead of issuing visas to foreigners that keep wages down. Let there be some natural wage pressure to reallocate resources. This is how a capitalist economy operates best. We need a greater emphasis on math and science as we all know. So let the job market pay more for those skills. Our lower school curriculum needs to be beefed up. We need to run education for the smart student instead of for the ego of the child who might get left behind. There is a choice here. Spare the slide rule, spoil the child. Leave a child behind or leave the country behind. You choose.

If education deficiency is our biggest problem then Larry Summers is right: we have a structural problem and face stagnation since we will not solve that one overnight. But I think our biggest problem is competitiveness and a lower dollar can do a lot to restore that in short order. But that will take political will.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.