Understanding the Great Deflation Part 2: Janet Yellen’s speech

by George Hatjoullis

The blog “Understanding the Great Deflation” attempted to provide an accessible introduction to the concept of deflation and the policy responses. Inflation and deflation were characterised as symptoms of underlying disease much like body temperature. The same symptoms can appear with any number of underlying diseases. Body temperature variations often lead to complications and in these circumstances doctors will treat the symptoms whilst addressing the underlying disease. However, the temperature variations are part of the immune response and thus not in themselves a ‘bad’ thing. The same is true of inflation and deflation. They are part of the economy’s immune response and symptoms of underlying problems. However, the symptoms can lead to complications so central banks try to limit the degree of deviation from whatever is deemed ‘normal’. Unfortunately, CBs seem to have either concluded that inflation and deflation are the disease and if they control these all else will follow or that their mandate only extends to symptom management. The result is that they only seem to address the symptoms often with perverse and potentially disastrous consequences.

The previous blog identified three underlying causes behind the global deflationary bias that is evident at present. First, the credit crisis of 2008 caused a jump in demand for cash and near cash risk free assets at the same time as the supply diminished. In part it diminished because of the policy response. Quantitative Easing removed risk free government debt from the system. Austerity reduced the primary supply of government debt. Bank balance sheet contraction (a policy response) reduced the supply of bank money. Removing the too-big-to-fail tag for large banks highlighted the credit risk embedded in uninsured bank deposits. The evidence is in widespread low to negative nominal interest rates. Second, extreme income inequality concentrated purchasing power in the hands of a few that have insufficient inclination to spend it on GDP, either for consumption or investment. Actual GDP has struggled to reach potential. We have poverty in the midst of plenty and no upward pressure on aggregated prices.  Low nominal wage growth is a symptom. Finally, technological change is expanding productive capacity faster than depreciation and obsolescence can destroy it. Aggregate investment is not expanding and even where employment is picking up, it is low quality and low pay.

The several blogs will test this summarised view of the economic world against policy and learned publications that I come across. The first to be so tested is Janet Yellen’s speech “Normalizing Monetary Policy: Prospects and Perspectives” (http://1.usa.gov/19q9CMT) of March 27, 2015. Janet Yellen is Chair of the Federal Reserve of the US.

The speech is the clearest statement of intent that I have ever read from a Fed Chair. They will begin the process of raising interest rates sometime this year. The Fed judge that the non-accelerating inflation, rate of unemployment (NAIRU) to be 5-5.2%. The unemployment rate is presently 5.5%. She acknowledges that inspite of this improvement in employment that she has some reservations about the underlying strength of the US economy.

Interest rates have been, and remain, very low, and if underlying conditions had truly returned to normal, the economy should be booming.”

Quite so and by implication the economy is not booming. She is posing the question that I have posed repeatedly in the blogs; after an unprecedented period of monetary accommodation why are we still limping along? In the absence of a clear answer to this question raising rates is dangerous and could prove a policy error. So why is the Fed expecting to raise interest rates this year?

“… we need to keep in mind… that the full effects of monetary policy are felt only after long lags… I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.” 

This is a remarkable paragraph. Despite acknowledging earlier that the very same lags would imply the US economy should already be booming, she is worried about stimulating such a strong inflationary response in two years time that the Fed will have to raise interest rates. Perhaps ,madame, you should explain why the economy is not booming now before worrying about the next two years. This criticism of policy makers also applies to the Bank of England and is the subject of my blog ” Bank of England Inflation reports: track record”. She continues;

“In addition, holding rates too low for too long could encourage inappropriate risk-taking by investors, potentially undermining the stability of financial markets.”

Inappropriate risk taking? The problem is not enough risk taking.  Excess demand for risk free near money assets and lack of productive investment do not signal inappropriate risk taking. Bank deleveraging does not signal inappropriate risk taking. Negative risk free interest rates and bond yields does not signal inappropriate risk taking. This is preposterous and dangerous. Janet Yellen is reading a dogmatic script from a foundation level economics textbook. Not what one hopes for from the Fed Chair.

The fear that Yellen has of inflation in two years seems to come from the falling unemployment rate.

An important factor working to increase my confidence in the inflation outlook will be continued improvement in the labor market. A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten…for this reason a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.”

How about a pick-up in nominal wage growth as a precondition Janet?

“…we can never be sure what growth rate of nominal wages is consistent with stable consumer price inflation, and this uncertainty limits the usefulness of wage trends as an indicator of the Fed’s progress in achieving its inflation objective.”

The question that comes to mind is, if nominal wages have no necessary correspondence to inflation, what is NAIRU and why base policy on it? Confused? You are the not only one. Neither evidence of wage or price inflation are preconditions for the Fed to raise interest rates. So what is a precondition? Nothing, as it turns out. The decision to raise rates has already been made, but do not worry says Janet because the path of rates is what really matters, and we are not expecting to raise very far.

“The FOMC will, of course, carefully deliberate about when to begin the process of removing policy accommodation. But the significance of this decision should not be overemphasized, because what matters for financial conditions and the broader economy is the entire expected path of short-term interest rates and not the precise timing of the first rate increase.”

The next paragraph explains the plan.

At present, the equilibrium real federal funds rate, which by some estimates is currently close to zero, appears to be well below the longer-run normal levels assessed by the FOMC… Provided that inflation shows clear signs over time of moving up toward 2 percent in the context of continuing progress toward maximum employment, I therefore expect that a further tightening in monetary policy after the first increase in the federal funds rate will be warranted.”

Inflation is not a determinant of the first rate increase but will determine the size and timing of further increases. In other words we are going to start raising rates this year whatever and see where it takes us. Moreover, we do not expect it to take us very far. One of the reasons offered about why rates may not rise very quickly is the asymmetry in monetary policy tools. It easier to raise rates to contain inflation than cut rates to stop deflation so erring on the side of caution is sensible. But surely this is also a good reason for not rushing to raise interest rates. So what was all the earlier guff about two year lags and risks of overdoing it?

This speech, for me, epitomizes the sad state of central banks and policy makers. They do not understand why aggressive policy has not achieved more but continue with the existing policy prescriptions (ignoring the evidence) and hope to be able to respond as they go along. Why will they raise rates this year? I think it is because they are bored.