Fed policy prepares to go off the rails
Yellen at the University of Michigan said that the Fed policy had transitioned from a policy of stimulating the economy to one of holding its gains. She said quite clearly that policy could no longer be run to cause the unemployment rate to drop. She noted that her own view and that of other FOMC members is that the rate of unemployment might already be below its equilibrium value. Throw down that gauntlet Janet!
Always and everywhere a monetary phenomenon…except now
She noted that US GDP growth is at 2% or a little less. When asked about monetary policy she said inflation was the product of economic slack, inflation expectations and some temporary factors like the dollar. But she did not mention money or credit and did not correct that omission later in response to a pointed question about 'Inflation being always and everywhere a monetary phenomenon.'
GDP gap…the same old crap
Not that I do not believe in the GDP gap. But I also believe in the money and credit. I do not like this swing of the pendulum for monetary policy that goes from extreme monetarism to extreme Keynesianism since no inflation model works all the time. I like to have balance. And one thing that is happening now is that in the guise of success Fed policy is actually starting to run badly off track. When Yellen was asked about what causes inflation she noted that her views on inflation causation really had not changed. And believe me that is NOT reassuring.
When the facts change I change my mind…what do you do?
This phrase is often associated with Keynes but his main biographers have not been able to pin down when he actually might have said it. So maybe it is a mis-attribution. But it serves me here since many of the old Keynesian relationships show such a shift. But with so many relationships not working as they used to, what has Yellen to gain by saying that she thinks things work as they always have when that clearly is not true? She mentioned two trends (closely related) the slower US GDP growth and drop off in productivity growth. And while she speaks of the economy 'doing well' growth in Q1 is pegged by the Atlanta Fed GDP-Nowcast at under 1%. The Fed oddly seems very comfortable hiking rates and planning a balance sheet shrinking party amid weak US GDP growth even as its main inflation progress has come courtesy of OPEC and its ability to jack up oil prices.
This is not supposed to happen: Warning! Don't try this at home
100% success as abject failure…
We have been watching the Fed stick to its Keynesian policy even as that has not worked. Has not worked you say? What do you mean? GDP growth is near 2% Yr/Yr which is the Fed's limit and the PCE headline is now up by 2.1% Yr/Yr above the Fed's target. That is 100% success! Well sometimes things are not what they seem. Remember economics is not just about an outcome but about a process and the Fed wants us to believe in its process and I think that is exactly what we should NOT be doing.
Back door policy success at the Fed
In a manner of speaking the Fed is hitting its goals through the back door. If Russell Westbrook needs three points to make his next triple-double and if he banks a long shot in off the glass from beyond the top of the circle, he will get credit for his three pointer but it will be inadvertent... lucky …but yes, it will count. Fed policy is aimed by using its Keynesian principles, but like Westbrook, the Fed is scoring off of bad shots and lucky bounces. Its policy theoretically is keyed off the central role of the unemployment rate and its relationship to inflation through economic slack. When unemployment gets low wages rise and rising wages put pressure on inflation and that causes the Fed to hit its full employment targets and to push inflation up to its goal as well. But while that works 'in theory' it is not happening. Low unemployment is being accompanied by falling or stable wages (average hourly earnings). There is no price pressure from wages through the Phillips curve. Price pressure in the headline is coming through oil prices courtesy of OPEC. In fact rising oil prices and headline inflation are undercutting stable to weak nominal wages causing real wages to drop. That is weakening the economy. So to the extent that the Fed seems right on the numbers its policy is not doing it and in fact its policy is in a tangle. (If you like good advice by coincidence rent the movie 'Being There' starring Peter Sellers.)
A Phillips Curve so flat that it's useless
Plan ahead but also watch your step
Yellen is totally focused on the period ahead. She acts as though the economy is where the Fed wants it and that the Fed only needs to nudge things here and there to keep it on path. But Fed monetary mechanisms did not get the economy here and so the Fed is in no position to nudge things back and forth. Its policy mechanism is shooting blanks. The fact that the Fed is not responsible for putting the economy in this sweet spot suggests that the policy moves it plans might actually destabilize things since the economy is not working the way that the Fed assumes. The economy looks much weaker. The Fed seems oblivious. The Fed plan to have a program of rate hikes topped off by a shrinking balance sheet is a huge risk.
The fallacy of the slow preemptive move up in rates
The Fed thinks it is nudging rates up slowing so that rates will not have to move up sharply later, a pattern that could destabilize growth. But in fact the current plan to hike rates and shrink the balance sheet may already be more than enough to destabilize an economy that is not growing that well and that is being undercut by having rising inflation which is eroding real wages.
Try not to bet on pure dumb luck
I think that the economy needs to be watched carefully since it is not following the Fed plan. The Fed is not hitting its targets except by pure dumb luck. The chance that the drunken sailor will walk exactly this way again is unlikely. It will be hard for the Fed to continue to luck into the policy path it has chosen since its monetary mechanisms are not working the way it thinks, nor is the economy responding to what the Fed thinks is its stimulus. Because of this, the Fed is just as likely to steer it in the wrong direction as in the right direction.
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.
Additional disclosure: Topical Macro article keyed off Yellen speech of today- time sensitive.