Six Major Flaws in the Fed’s Models

For now, the US dollar is the dominant global reserve currency.

The value of the dollar affects all markets, including stocks, bonds, currencies and commodities. Interest rates determine the value of the dollar — in effect, its ‘price’.

When the US Federal Reserve manipulates interest rates, it is manipulating…and therefore distorting…every market in the world.

The original sin

The Fed may have some legitimate role as an emergency lender of last resort and as a force to use liquidity to maintain price stability. But the lender of last resort function has morphed into an all-purpose bailout facility…and the liquidity function has morphed into massive manipulation of interest rates.

The original sin with regard to Fed powers was the Humphrey-Hawkins Full Employment Act of 1978 signed by President Carter. This created the ‘dual mandate’ which let the Fed consider employment as well as price stability in setting policy.

The dual mandate lets the Fed manage the US jobs market — and by extension, the economy as a whole — instead of confining itself to straightforward liquidity operations.

Fed chair Janet Yellen is a strong advocate of the dual mandate. She has emphasised employment targets in the setting of Fed policy.

Through the dual mandate and her embrace of it…and using the US dollar’s unique role as leverage…Yellen is a de facto central planner for the world.

Like all central planners, she will fail.

Massive theft from savers

Yellen’s greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that don’t correspond to reality.

This approach is highlighted in two Yellen speeches. In June 2012, she described her ‘optimal control’ model…and in April 2013 she described her model of ‘communications policy’.

The theory of optimal control says to abandon conventional monetary rules in current conditions in favour of a policy that will keep rates lower, longer than otherwise.

Yellen favours use of communications policy to let individuals and markets know the Fed’s intentions under optimal control. The idea is that over time, individuals will ‘get the message’ and begin to make borrowing, investment and spending decisions based on the promise of lower rates.

This would then drive increased aggregate demand, higher employment and stronger economic growth. At that point, the Fed could begin to withdraw policy support in order to prevent an outbreak of inflation.

The flaws in Yellen’s models are numerous. Here are a few…

  1. Under Yellen’s own model, saying she will keep rates ‘lower, longer’ is designed to improve the economy sooner than alternative policies. But if the economy improves sooner under her policy, she will raise rates sooner. So the entire approach is a lie.

    Somehow, people are supposed to play along with Yellen’s low rate promise…even though they understand that if things get better the promise will be rescinded. This leads to confusion.

  1. People are not automatons who mindlessly do what Yellen wants. In the face of the embedded contradictions of Yellen’s model, people prefer to hoard cash, stay on the sidelines and not get suckered by the bait-and-switch promise of optimal control theory.

    The resulting lack of investment and consumption is what is really hurting the US economy. Economists call this ‘regime uncertainty’ and it was a leading cause of the length, if not the origin, of the Great Depression of 1929–1941.

  1. To make money under the Fed’s zero interest rate policy, banks are engaging in hidden off-balance sheet transactions, including asset swaps, which substantially increase systemic risk.

    In an asset swap, a bank with weak collateral will ‘swap’ that for good collateral with an institutional investor in a transaction that will be reversed at some point. The bank then takes the good collateral and uses it for margin in another swap with another bank.

    In effect, a two party deal has been turned into a three-party deal with greater risk and credit exposure all around.

  1. Yellen’s zero interest rate policy constitutes massive theft from savers.

    Applying a normalised interest rate of about 2% to the entire savings pool in the US banking system — compared to the actual rate of zero — reveals a US$400 billion per year wealth transfer from savers to the banks from the zero rates. This has continued for six years, so the cumulative subsidy to the banking system at the expense of everyday Americans is now over US$2 trillion.

    This hurts investment, penalises savers and forces retirees into inappropriately risky investments such as the stock market. Yellen supports this bank subsidy and theft from savers.

  1. The Fed is now insolvent. By buying highly volatile long-term Treasury notes instead of safe short-term treasury bills, the Fed has wiped out its capital on a mark-to-market basis.

    Of course, the Fed carries these notes on its balance sheet ‘at cost’, and does not mark to market…but if they did, they would be broke. This fact will be more difficult to hide as interest rates are allowed to rise.

    The insolvency of the Fed will become a major political issue in the years ahead and may necessitate a financial bailout of the Fed by taxpayers. Yellen is a leading advocate of the policies that have resulted in the Fed’s insolvency.

  1. Market participants and policymakers rely on market prices to make decisions about economic policy.

    What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation and then you rely on the ‘price’ to guide your policy going forward. This is the blind leading the blind.

    The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run.

What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation and then you rely on the ‘price’ to guide your policy going forward. This is the blind leading the blind.

The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run.

Once you change all this psychology, it is extremely hard to change it back again. If the Fed succeeds in raising inflationary expectations, those expectations may quickly get out of control as they did in the 1970s. This means that instead of inflation levelling off at 3%, inflation may quickly jump to 7% or higher.

The Fed believes they can dial-down the thermostat if this happens. But they will discover that the psychology is not easy to reverse and inflation will run out of control.

The solution is for Congress to repeal the dual mandate and return the Fed to its original purpose as lender of last resort and short term liquidity provider.

Central planning failed for Stalin and Mao Zedong…and it will fail for Janet Yellen too.

Regards,

James Rickards,
Contributing Editor, Money Morning

James G. Rickards is the editor of Strategic Intelligence, the newest newsletter from Agora Financial. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.

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