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2007 All Over Again, Part 4: “We Are Outsourcing Our Monetary Policy”

In that deservedly-famous 2006 CNBC debate between Peter Schiff and economist Arthur Laffer (in which the latter manages to be both arrogant and wrong about literally everything), Laffer celebrates the fact that “we are outsourcing our monetary policy to China” (minute 5:17).

Alert listeners probably wondered what he meant by that, and also probably found the idea vaguely disturbing. But whatever it was we were doing, it turned out to be bad because within a year the global economy was in free-fall.

And now that strange, ominous concept has returned — but this time we’ve put our monetary fate in even less-stable hands:

Yellen Outsources U.S. Monetary Policy to the Financial Markets

(Bloomberg) – Fed Chair Janet Yellen told the Economic Club of New York on Tuesday that policy makers had scaled back the number of interest rate increases they expect to carry out this year after investors did the same.

She argued that the downgrading of rate expectations in the market had led to lower bond yields, providing the economy with needed support in the face of weaker growth overseas. The Fed then followed suit this month by reducing its anticipated rate hikes in 2016 to two from four quarter-percentage point moves projected in December.

“That’s a good thing,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, commenting on the sequence of actions. “Monetary medicine gets into the blood stream faster if the public can anticipate what the Fed’s response to an economic shock will be.”

There are pitfalls. Investors may become so impressed with their ability to influence Fed policy that they’ll press for more stimulus than the central bank is willing to supply.

Forcing Fed
“The risk is that markets’ perception of such continued accommodation will embolden them even more to try to force the policy hand of the Fed,” Mohamed El-Erian, chief economic adviser at Allianz SE and a Bloomberg View columnist, said in an e-mail.

Indeed, investors in the federal funds market are betting that the central bank will raise rates just once this year, not the two times policy makers envisage.

The Fed’s experience over the last six months also shows how difficult it can be for the central bank to align investors’ view of optimal monetary policy with that of its own.

“It’s a constant learning process by both the Fed and the markets,” said Joachim Fels, global economic adviser for Pacific Investment Management Co., which oversees $1.43 trillion in assets.

Automatic Stabilizer’
Yellen used her spoken remarks though to extol the symbiotic relationship between the central bank and the financial markets. “This mechanism serves as an important ‘automatic stabilizer’ for the economy,” she said.

Her comments come against the backdrop of continued criticism from Republican lawmakers and economists that the Fed is following a discretionary monetary policy that investors don’t understand and is hurting the economy as a result. They want the Fed to follow a monetary policy rule, such as the one espoused by Stanford University professor John Taylor. It uses a simple equation to link changes in interest rates to movements in inflation and the economy.

With her remarks on Tuesday, Yellen was “implicitly defending the Fed’s approach in the rules versus discretion debate as being one that’s systematic” and understood by the markets, Crandall said.

I’m not going to try to explain (or even understand) any of this, except to say that putting oneself at the mercy of financial market sentiment seems a bit risky, given that Mr. Market is a well-known manic depressive.

It’s also an inversion of the proper relationship between “money,” or more accurately the monetary environment, and the players who act on that stage. Placing monetary policy in the hands of stock, bond, and derivatives traders is like putting the definition of meters and seconds into the hands of Olympic athletes: Within a few years the self-interest of the participants will make past records meaningless.

Some other fun analogies: putting criminals in charge of the legal system, putting kids in charge of the dinner menu, putting car makers in charge of auto safety testing, putting food companies in charge of nutritional reporting. All are recipes for incoherence if not disaster.

Apply the same process to interest rates and currency creation, and the price signaling mechanism of the capital markets will go haywire. And without accurate price signals, modern market-based capitalism descends into chaos.

8 thoughts on "2007 All Over Again, Part 4: “We Are Outsourcing Our Monetary Policy”"

  1. Yeah, in 2006 I was losing business as a Realtor warning nice young couples to not buy, and warning Seller’s to please don’t over price and get trapped when prices fall. But even the National Association of Realtors Chief Economist stated in 2006 that “the bottom was in” in the housing market. I absolutely couldn’t believe the carp I was hearing then. To me the economy was screaming (I warned buyers beginning in 2003 to be careful. That’s when lender’s got all thrilled about liar loans.
    The deal is this. The housing bubble was just an overture of the mother of all bubbles fermenting now. And for the life of me, I’ve never been more astonished than now about how clueless so many people are now. People across the “educated” spectrum. Doctors, Realtors, economists, news heads, teachers, and most people of all professions. It’s absolutely surreal. I do think this government of ours is capable of thinning out our foundations until we attain consummate collapse capability. But even then, 2017 might be a stretch. As we continue to weaken, people will see it. And as more do, the weakening will be seen by more and more as inevitable. In which case, as a Realtor, let me warn you now. Be the first to panic. Waiting will become risky. And if you think you can just stay in your homes, you’re not thinking deeply enough.

  2. Expectations Theory, Yellen variant. Wow! Janet is really up the creek without a paddle because she is grasping at straws to justify a monetary policy that has been way too loose for way too long. There exists no disciplined link between the financial markets and the Fed, the Fed killed that link when it began unconventional QE variations after the 2008 Collapse.

    Now she is justifying her lack of fortitude and monetary discipline by suggesting that the markets have already provided stimulus via a lowering of longer term rates based on the Fed’s inability to take the punchbowl away after going on 8 years! So who’s on First here?! The Fed is abdicating its responsibilities of financial market orderliness, and letting the patients run the asylum.

    The Fed needs to be abolished. These types of statements on the eve of massive debt defaults around the world brought on by unprecedented monetary laxness is just another example of monetary authorities that don’t have a clue what they are doing or what to do at this point.

    Her statement makes no sense. The Fed doesn’t have to tighten credit further because the marketplace has already factored in the maintenance of low rates. Duh? Rates should be up in the marketplace to justify a Fed sitting on its collective, fricking hands, but that’s what we pay them for, right??!!!!!!!!!!!!!!!!

  3. Actually, I like the idea of the markets setting the level of interest rates. Of course, I’m saying we should do away with the FED and allow the Free Market to set rates.

    FED rate setting, by its very nature, hurts our Economy. If rates are set above Free Market rates, then some economically worthwhile projects do not get funded. If rates are set under Free Market rates, then some projects with doubtful economic viability will get funded. Either way, the FED rate setting would move capital away from the optimum.

    And then there’s the money supply. To set rates low, the FED MUST create new money, causing prices to be higher than they would be otherwise, discouraging saving. A higher FED set rate would pull money out of the Economy, causing distortions usually referred to as deflationary.

    Continuing to allow the FED to screw with interest rates is the big issue. Whether they manipulate using a set rule, or manipulate by whim, matters very little to me.

    Bob Shapiro

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