Friday, April 4, 2014

The Yellen Fed Doesn't Sound Like A Central Bank

Too much was made over the choice of successor to former Fed Chairman Bernanke.  Making the choice a political or gender equity issue would not have been a good thing, and it seemed logical that someone who had been a longstanding partner to Bernanke would assure continuity, thereby assuaging nervous markets.

Unfortunately, the early "communications" issues have unsettled even the most experienced Fed watchers I know and respect. John Cochrane, AQR Professor of Finance at Chicago Booth School of Business, has identified the underlying problem as being that central banking globally has morphed into something that it is not, claiming powers that it does not have.

That was made manifest recently, in Fed Chair Yellen's public pronouncement about the Fed focusing its policies on labor markets and unemployment.

Given that macroeconomic models don't incorporate any kind of realistic financial sector, and given our very weak recovery, in its fifth year, had its origins in the financial sector and asset markets, no responsible economist could claim that the Fed has the understanding or tools to address failures and frictions in the labor market.

As we've written about many times, unconventional monetary policies such as quantitative easing and unbounded periods of low interest rates have have essentially done nothing for the economy, as evidenced by the unemployment rates.  Again, as we warned from the outset, these novel constructions would have unintended consequences given our lack of experience with their mechanism of action.

Former BIS Economic Adviser William White's paper, which we've cited before, is still worth reading. Focusing on the shadow banking system, he cites research suggesting the shadow banking system was procyclical in the credit upturn, which seems well agreed upon; he also suggests that it may be procyclical in the credit downturn, which is debated.  In a simple model, he shows that the behavior of this sector and our financial sector as a whole, may be a powerful mechanism for increasing inequality of both income and wealth.

Right now, we have a disconnect between expectations for what central banks can achieve (remember Mario Draghi?) and what they really can do.  Dodd-Frank has made the Fed the de facto Regulator-in-Chief of the financial sector, and the guardian of asset prices, housing prices, and architect of financial stability.  To this we are adding labor markets and unemployment.

We've written before that one of the greatest strategic blunders made by the Bernanke Fed was to effectively become an enabler for fiscal profligacy by his employers in the White House and Senate.  The role of the Fed Chair historically was more 'big picture' focusing on rates, inflation, and the currency.  This is a massive agenda in itself, but the Fed was never to be the engineer of policy.  It provided the backdrop for markets to set the term structure of rates and for the economy to move forward with real economic growth.

When warranted, the Fed Chair would call for fiscal responsibility from the executive and legislative branches, and sometimes the Chair would have to 'lean against the wind,' even if only rhetorically.  That's because the Fed was always independent of elections, politics, and of the noisy public square, including Wall Street.

Today, the Fed no longer makes any call for responsible fiscal policy, and now it is firmly in the camp of perpetuating the current status quo of discretion based, as opposed to rules based policies, which is disquieting to experienced Fed watchers who could always infer a path from Taylor Rules and the like. Now, all bets are off. So, financial markets continue to soar, our inflation rate is minimal, corporate profits are up, and the bubbles continue in corporate assets (companies) fueled by large appetites for investment grade corporate debt.

Meanwhile, the traditional financial sector, namely the six mega-banks are effectively becoming ensconced as the heart of our financial system, with no effective competition.  We still don't know what systemically important means, as we randomly suggest that it applies to insurers like Met Life and to asset managers.

Because of the cynical way in which Dodd-Frank was passed, the regulations that will be at the heart of the future evolution of the system and the source of shocks, are being written away from the eyes of the electorate by anonymous lawyers and policy wonks, all aided and abetted by their favored activists and lobbyists.

The final problem facing central bankers is the IMF's incessant clarion call for national central banks to make their decisions in "a global framework."  This sounds like an innocuous platitude, leading to many meetings at tony locations with lots of papers and meaningless declarations. John Cochrane adds that the real motive may be to pool together all the lenders of last resort and to spread the costs of carrying the weaker players among the stronger players. Our Federal Reserve and the taxpayers certainly doesn't need to take on that burden too.

Central bankers need to be independent of politicians and of Wall Street gunslingers, and their measured, predictable tweaks to the economic engine which enhance growth, moderate cycles and preserve the value of the currency are their most valuable contribution to Main Street.

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