The Law Of 2%

This is a syndicated repost courtesy of Alhambra Investments. To view original, click here. Reposted with permission.

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It would be preferable, of course, if what Janet Yellen said in any setting made little noise whatsoever. We aren’t nearly there yet, but are moving in that direction. Her testimony today before Congress in the Fed’s semi-annual Humphrey-Hawkins kabuki relic might actually help in that matter.

If economists like Yellen were caught so unprepared for what happened after 2014 because of their view of what was happening in 2014, that wasn’t supposed to be the case in 2017. This partly is the fault of policymakers who stoked expectations or at least failed to clarify what “rate hikes” actually mean in the post-“rising dollar” context. It simply does not represent what it would have had things gone the way they were supposed to just a few years ago.

Instead, almost a year and a half from the trough of what was a serious global downturn, and now three years after its initiation, Yellen manages to deliver this pearl of wisdom:

I see roughly equal odds that the U.S. economy’s performance will be somewhat stronger or somewhat less strong than we currently project…

Thanks for clearing that up, professor. The media and the mainstream continue to frame monetary policy as a choice between hawkishness and dovishness; continued accommodation or its determined removal. This is the wrong way of contemplating what are going to be serious (psychological) changes.

It starts with the state of monetary policy itself. As I wrote before in describing the true meaning of Humphrey-Hawkins, it relates to the evolution of money:

Twice a year every year, the Chairman of the Federal Reserve drives up to Capitol Hill and formally reports to Congress. Given our current circumstances, these ceremonial affairs are lent a great deal of mainstream scrutiny as the public tries to parse the smallest scraps of unanticipated deviations from the carefully laid script. In many ways, this is a rerun of the late 1990’s dot-com bubble, but in reverse. When Alan Greenspan would testify, even his briefcase would be subjected not to so much scrutiny but reverence for what the Fed would not have to do…Janet Yellen testifies, the world waits with baited breath for her to endorse instead the smallest little something that the Fed might have got right.

The original law required the Fed to produce monetary targets, because by 1975 even the politicians in Congress could so easily appreciate the links between money and inflation. House Concurrent Resolution 133 passed that year, starting the process toward what would become the Full Employment and Balanced Growth Act of 1978; or Humphrey-Hawkins. In a little known provision now lost in the mystique of Alan Greenspan, it called for first reducing inflation to less than 3%, and then eliminating it altogether by 1988!

How, then, has the Fed been able to get away with being in violation of what seems an unambiguous statutory obligation? The answer is that the central bank was given a loophole of sorts, a provision in the law that said the Fed should work toward this goal provided it doesn’t interfere with its other duties, especially those under the Employment Act of 1946. It was that prior law which formed the basis of Humphrey-Hawkins in the first place (in the 1976 Senate hearings for the bill, Senator Hubert Humphrey decried that the 1946 law “had been conveniently ignored”) because of how runaway inflation was interfering with employment.

What instead evolved was a monetary policy doctrine increasingly departed from money, but also that further stated 2% inflation was necessary to achieve stable, low unemployment. It was and remains a huge contradiction, made even more (despicable?) so because of the monetary genesis of inflation.

Inflation is caused by money, and the Fed needs, it declares, some inflation in order to affirm its requirements under the 1946 Act. The Fed by the 1990’s could no longer define money, therefore how could it define stable inflation and therefore employment as required by both laws?

The Humphrey-Hawkins Act had imposed upon the FOMC the further duty to set monetary targets so as to achieve this balancing act. The provision for those targets, however, sunset in the year 2000, requiring re-authorization by Congress at that time. The FOMC in recommending to the legislature that they be allowed to expire admitted what Alan Greenspan had been hinting at in even his most famous speeches throughout that prior decade of the so-called Great “Moderation.” From June 2000:

CHAIRMAN GREENSPAN. The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.

The FOMC didn’t even debate the prospect. Greenspan instead said, “But it is my intention, if it is all right with everyone, to forgo both a discussion and vote on these ranges.” He didn’t want to waste FOMC time on even bringing up the subject of monetary targets because they stopped using them years before.

It calls into question what really happened in the 1990’s, which is highly relevant to Yellen’s now experience with the “conundrum”, as well as the mainstream’s wrongheaded obsession with “hawkish” and “dovish.”

Federal Reserve policy had been transformed from monetary policy as it was (at times) in the 1970’s and before to discretionary federal funds rate targets starting sometime in the 1980’s. This is not a difference that can be overstated. In other words, the Fed simply assumed that its policy changes were having monetary effects only by the eventual result on the rate of inflation: if money causes inflation, and inflation is at or near target, then monetary policy must have the “right” money. It didn’t know that was the case, but given the history of the CPI and then PCE Deflator it made the judgment of cause and effect without any evidence.

Thus, when Milton Friedman wrote in August 2003 that Greenspan’s Fed hadn’t really achieved anything that other central banks around the world had, often using very different policy criteria, it struck at the heart of this monetary assumption (which is why the criticism coming from Friedman must have been especially painful for policymakers). What he meant was that Fed officials were assuming a correlation of what they did with inflation was more than that, when a global survey suggested it wasn’t. They were taking credit for something else.

The Great “Moderation” wasn’t just a US phenomenon at all, and therefore given the monetary aspects of inflation it couldn’t have been due to Federal Reserve monetary policy. Policymakers were making assumptions that weren’t backed by evidence (the dot-com bust and recession very strong contemporary proof of monetary policy contributing very little in money).

In the most recent Humphrey-Hawkins testimony, the current Fed Chair now has a big inflation problem; no matter what the central bank does, or any central bank, they can’t get any. If the Fed claims it requires 2% inflation to achieve the required balance to all its mandates, and after considerable effort still can’t hit that mark, then monetary policy is in trouble in so many different ways.

She is left to instead suggest, as she has from almost the first day of her tenure back at the beginning of 2014 (she really should think about publicly criticizing Bernanke for leaving her holding the bag, not that she wasn’t involved during his terms), that inflation will eventually move back up to 2% after “some time.” In the world of politics, I suppose ten years, many of them under ZIRP, with four QE’s thrown in, already qualifies as “some time.” It appears to be the new “transitory.”

In the real world, it qualifies instead as they really don’t know what they are doing. Officials assumed they did so long as things (undefinable money) were moving on the up. Now that they aren’t, they have no idea what’s really going on or why. Her statutorily-required testimony could easily be scrapped in its entirety and substituted by one appropriately hollow sentence: inflation will be 2% because it has to be 2%, right?

Humphrey-Hawkins was initially the result of clear monetary imbalances that through high inflation reduced economic efficiency so much as to create clear hardship for Americans. Our current case is the same if inverse; clear but negative monetary imbalances that in persistently low inflation presents evidence of a money anchor or drag that has created a clear and even greater economic hardship for Americans, especially in employment. It’s not laws that matter but money, which was the whole point of Humphrey-Hawkins in the first place; to force by law the Fed to do its damn job in money.

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