Mitchell’s Musings: 12-18-2017: Benefits and Losses and Uncertain Results

15 Dec 2017 1:16 PM | Daniel Mitchell (Administrator)

NOTE TO READERS OF THIS BLOG: I have become aware of a quirk in the EPRN system that can cause incorrect graphics to appear in past musings. Essentially, if an image file was used with a filename such as "Figure 1," and then a later post uses a different image file with the same name, the most recent version ends up in both musings. I will try to correct past errors that may have accumulated in past musings, if time permits. However, all past musings are also posted at:

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Mitchell’s Musings: 12-18-2017: Benefits and Losses and Uncertain Results

Daniel J.B. Mitchell

As we have noted in earlier musings, the leadership of the Federal Reserve is changing. And it appears that the Trump replacements on the Fed are likely to tilt toward non-economists, mainly banker/business types. That outcome may turn out to be a Good Thing, even if an accidental result, compared with what could have happened. (Obviously, the Fed’s research staffs, both at the Board of Governors and the regional banks, will continue to be professional economists.) The danger with Trump was that he might have picked either an ideologue economist – perhaps an old-fashioned monetarist still puzzled why there isn’t a roaring inflation and convinced it is about to happen – or a wacko with a leaning toward the gold standard and/or who-knows-what-else. That’s the benefit of the choice he actually made recently. Not an ideologue. Not a wacko.

The best choice would have been to continue with incumbent chair Janet Yellen.[1] That’s the loss. President Trump instead went with another member of the Fed’s Board of Governors as the new chair, a lawyer and banker, Jerome Powell.[2] Most recently, the administration has assured us that there won’t be a recession anyway so not-to-worry.[3] And, of course, none is forecast at present by outside economists within a reasonable forecasting horizon (which isn’t all that long). There are some signs of a potential bubble in the making in financial markets, some real estate markets, and the fraud-prone/fraud-encouraging bitcoin market. But there are some challenges, even assuming that no recession is looming.



One challenge is that – since the old economic models aren’t working – the Fed itself will make a mistake and cause a recession. To old-fashioned monetarists, the fact that the monetary base substantially increased due to the Fed’s response to the Great Recession means, as noted above, that the inflation rate should have (substantially) responded. Other economists, who are less ideological, tend to fall back on the notion of a natural rate of unemployment which will produce wage and price inflation once the actual rate falls below it. You would have to go back to the late 1960s or even to the Korean War – both periods with notable inflationary pressures – to find unemployment rates well below the current levels. So the conventional wisdom – and the seeming external consensus – is that the Fed should do a classic taking-away-the-punch-bowl-just-as-the-party-starts. That is, it should be slowly raising interest rates (which it has been doing). But overly-aggressive punch bowl grabbing could cause a reversal, particularly if some markets are verging on bubbles.



There is also a seeming consensus that because the Fed acquired substantial financial assets in response to the Great Recession and its aftermath in an attempt to stimulate the economy, it should now be selling off those assets because the size of its portfolio is abnormal. But it is unclear why a central bank holding more assets than usual is a Bad Thing. More importantly, if acquiring those assets was seen as a stimulus, wouldn’t selling them be contractionary? No one seems to be asking such questions. Will a lawyer/banker Fed chair ask them? Will he question the consensus?

One had the sense that, at least behind the scenes, Chair Yellen was more pragmatic about what the Fed should be doing than the external consensus that seems fixated on some notion of getting the Fed back to “normal.” The Fed is a central bank, and so it is not a normal institution with normal constraints that an ordinary bank would have. Of course, it might be argued that having non-economists in charge of the Fed will actually lead to pragmatic questioning of the consensus. But the reverse could also be true.

We do know that as the economy began to falter in 2008, Yellen’s predecessor as Fed chair – academic economist Ben Bernanke, a student of the Great Depression – ended up being a key player in stemming the collapse. Would a lawyer/banker as Fed chair be able to play that role? No one knows. Only if you assume that a recession at some point during the new chair’s reign is impossible is the answer to that question irrelevant.






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