Five Takeaways from the House's Yellen Hearing
On Wednesday, Janet Yellen testified before the House Financial Services Committee. Though the hearings lost much of their appeal when Dr. Ron Paul retired from Congress, the House Republicans have maintained a reputation for being far more hostile to the Federal Reserve than their colleagues in the Senate — managing to generate some worthwhile moments. While little news was made, with Yellen maintaining her support for generally low interest rates, there were some points made today worth noting.
1) Republicans Continue to Push on the Fed’s Subsidy to Wall Street
Starting in 2008, the Federal Reserve has paid interest on excess reserves parked at the Fed. While this had never been done prior to the financial crisis, this policy has now become a vital tool for the Fed in setting short-term interest rates. As the Fed has increased the Federal funds rate, so too has it increased its “Interest On Excess Reserves” (IOER), now paying 1.25% on the over 2 trillion banks hold at the Fed.
This policy has drawn increasing criticism from House Republicans, and Yellen faced criticism from both Committee Chairman Jeb Hensarling and Rep. Andy Barr, who hold Dr. Paul’s old position as chairman of the monetary subcommittee. Accurately, both men highlight that this policy means the Federal Reserve – and by extension the US Treasury that would otherwise receive these interest payments – are directly subsidizing large Wall Street and foreign banks. Considering these IOER payments are projected to be $27 billion this year, it’s good to more attention be brought to this obvious example of Wall Street cronyism.
2) Higher Interest Rates for Wall Street, not for Main Street
Continuing on the subject of IOER payments, Rep. Barr also highlighted that average consumers are not seeing any payoff from higher interest rates. Interest payments on CD’s remain historically low, with many consumers unable to get the 1.25% the Fed is giving their financial institutions.
As the Wall Street Journal documented, a reason for this is the way a decade of low interest rates have changed the consumer-bank relationship. All of this is simply another demonstration of how policies by the Federal Reserve are benefitting Wall Street at the direct expense of the rest of the country.
3) Maxine Waters Wants to Make Poor People Poorer
Maxine Waters may be best known these days for being one of Donald Trump’s most vocal critics, but she is also the leading Democrat on the Financial Services Committee. On Wednesday, Waters questioned Yellen on why mainstream inflation measures have been constantly undershooting the Fed’s 2% inflation target, and voiced her disagreement with the Fed’s minor increases in the Federal funds rate.
The way politicians like Ms. Waters discuss inflation makes it clear that they don’t truly comprehend how it presents itself in real life. After all, as someone who constantly fundraises off the dangers of income inequality and the plight of low income Americans, surely the last thing Ms. Waters would want to see is for the purchasing power of the dollar decline for the very people she claims to want to help.
4) Hensarling References Marvin Goodfriend
Earlier this week it was reported that President Trump will nominate former Treasury official Randal Quarles Fed Vice Chairman. During the hearing, Chairman Hensarling quoted another economist who has been connected to another Fed vacancy: Marvin Goodfriend. As a Treasury Secretary finalist who has worked with the Administration on banking regulation, Hensarling evoking Goodfriend is being taken by some a sign that his nomination is now simply a matter of when.
Unfortunately Goodfriend’s surname is misleading, as he has been a vocal advocate of negative interest rates. His nomination would be a devastating betrayal by Trump of his blue-collar base, for the reasons he himself articulated as a candidate.
5) Yellen still hates Audit the Fed
Thanks to Dr. Paul, the head of the Fed now knows to expect one question about Auditing the Federal Reserve. This time it was Rep. Bill Posey, who tried to push Yellen away from her default defense of mythical Fed independence. Mr. Posey repeatedly asked Ms. Yellen to name a single instance where the Fed would have been negatively impacted by a full audit.
The Fed Chairwoman was unable to provide an answer.
Fed Raises Rates — Will Other Central Banks Follow?
Fed Officials Can't See What's Right In Front Of Them
While the Federal Reserve has an explicit dual mandate to keep prices stable and maintain full employment, they have unofficially taken on new goals like maintaining financial stability. Bernanke, Yellen, and other officials have noted how traditional monetary policy is a limited and blunt tool to accomplish this goal, which is why the Fed has, in recent years, exercised and flexed its regulatory muscle.
The Minnesota District Bank president, Neel Kashkari, recently wrote an article about the dilemma the Fed faces regarding asset bubbles and whether or not they should be met with raising interest rates. He summarizes in five points:
- It is really hard to spot bubbles with any confidence before they burst.
- The Fed has limited policy tools to stop a bubble from growing, even if we thought we spotted one.
- The costs of making policy mistakes can be very high, so we must proceed with caution.
- What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble. And finally,
- monetary policy should be used only as a last resort to address asset prices, because the costs to the economy of such a policy response are potentially so large.
In an addendum to his article, he admits that it is possible artificially low interest rates increase the probability of asset bubbles forming: “low rates ... could make bubbles more likely to form in the first place.” He laments that there is no economic theory to back this up, to the unending frustration of Austrian economists everywhere. Indeed, F. A. Hayek won a Nobel Prize in economics in part for his work on a business cycle theory that blames central banks for causing, among other things, bubbles.
ABCT Isn’t So Controversial
Despite the lack of representation in Federal Reserve and government offices, the theory is not as controversial as it is made out to be. Just a week before Kashkari’s post, Bloomberg.com published an article on a bubble in the automobile industry that singled out the cause of increased subprime auto loans: “While caution may be good for banks’ balance sheets, it doesn’t offer much relief for automakers, who relied on cheap credit to fuel a seven-year stretch of booming sales.”
In fact, artificially low interest rates and expansionary monetary policy have the explicit goal of stimulating borrowing and spending. This is no secret, as Kashkari explains: “we lower interest rates to try to stimulate economic activity by reducing borrowing costs.”
Now take Kashkari’s first and second points in view of this. If central bank policy is responsible for creating bubbles, then how could a central bank official say that spotting and preventing bubbles is “really hard”? It’s like a detective admitting he’s stumped about who is starting all of these fires around town, while he’s holding a container of fuel, a matchbook, and a book titled Arson for Dummies.
Broken Clocks and Broken Records
While Hayek certainly deserved his Nobel Prize, it is well-known that he was following Ludwig von Mises and his work on business cycles. Together, they constructed the framework for what we know today as Austrian business cycle theory, expounded and expanded more recently by Murray Rothbard, Joseph Salerno, Roger Garrison, Jesús Huerta de Soto, David Howden, Philipp Bagus, and many others.
Kashkari referred to those who try to identify bubbles as broken clocks. This characterization is unfortunate. Broken clocks do not explain why. If Austrian economists were only accidentally right some of the time, then they would not be able to point to the specific causes of the business cycle.
A broken clock, for example, would not explain, pre-1929 crash, the causes of the “inevitable crisis”:
Government agencies responsible for financial policy, directors of the central banks of issue and also of the large private banks and banking houses ... failed to recognize the fundamental problem. They did not understand that every increase in the amount of circulation credit (whether brought about by the issue of banknotes or expanding bank deposits) causes a surge in business and thus starts the cycle which leads once more, over and beyond the crisis, to the decline in business activity. In short, they embraced the very ideology responsible for generating business fluctuations. (Ludwig von Mises, Monetary Stabilization and Cyclical Policy, 1928)
Perhaps a broken record is a more apt analogy for modern central bankers (even a broken clock is right occasionally). After every financial crisis, in the midst of every recession, we hear the same line: “Let us stimulate the economy with expansionary monetary policy.” There is no adequate explanation of where the crises keep coming from, except for vague accusations against unregulated financial markets. And there is always another crisis on the way. The booms and busts are taken as a given, it seems. The Fed doesn’t try to solve the problem of the business cycle. They have given up on that task — they just try to make them smaller and smoother when they do come. Kashkari admits this in his article (point four): “What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble.”
The High Costs of Artificial Credit
Finally, Kashkari’s remaining words of warning in points three and five, that bad monetary policy is very costly, are the same as Mises and Hayek’s words of warning. The only difference is what counts as a “policy mistake” and where to look for the costs of wrong-headed policy.
For Mises and Hayek, the policy mistake involves any creation of credit out of thin air. If the Federal Reserve decreases interest rates below what would prevail on an unhampered credit market, then an artificial, unsustainable boom is set in motion. If any central bank increases the money supply through the financial system, it means that borrowers have the privilege of being the first to bid up prices as the new money ripples through the economy.
It means that nominal incomes, employment, consumption, the prices of capital goods, and other asset prices will increase. It means that capital will be directed into new, longer, and riskier lines of production, beyond what would have happened at the prevailing levels of real saving. These lines of production will turn out to be unprofitable as the increasing scarcity of capital becomes apparent and the costs of production become prohibitively high. Incomes, employment, consumption, and stock prices plummet as laborers and capital owners seek productive and profitable employment. The bust is made up of all of the necessary corrections for the errors made during the boom. Additional artificial credit will only delay this process and make it more painful when the day comes.
Contrast this view with that of Kashkari or this supportive Business Insider article: “the main, unspoken reason for pushing interest rates higher was to tame runaway stock and credit markets, which have broken all sorts of records under the Fed’s zero-rate policy ... [Kashkari] makes a solid case in an essay this week as to why this is a terrible idea.” They seem to understand that fiddling with interest rates and flooding the economy with artificial credit has numerous unintended consequences and potentially high costs.
Why is it such a stretch to posit that the bubbles, recessions, and depressions created by these policies are too high a cost? Why is it so controversial to suggest that we should leave interest rates and credit markets alone? Perhaps monetary policy is not a blunt tool, but a dangerous weapon — one that should be confiscated from those who have wielded it for too long.
Fed Minutes: Details on the Balance Sheet Plan
May's FOMC minutes were released at 2:00 eastern today and included the same self-confidence about the strength of the economy, the progress on inflation, and the good employment numbers. Any sign of weakness, especially in the GDP numbers were waved away as being "transitory."
Besides these things being used as justification for further rate hikes, we also received more detail about their balance sheet plans. In short, so as not to scare the markets, they are aiming merely to taper back on the dollar amount of reinvestment of the maturing debt. That is, rather than selling their debt holdings to shrink the balance sheet back to normal levels (which are not actually going to be at "normal" levels), they are going to start by halting their reinvestment program. However, before quitting cold turkey on the reinvestments, it appears that they are aiming to agree on a certain dollar amount of holdings that will be allowed to run off.
The WSJ summarizes:
Fed Speeches: What They Said
Fed Vice Chairman Stanley Fischer spoke first on Friday morning and made it clear that the Fed's discretionary approach to monetary policy was to be preferred over a "rules-based" approach. That is, the flexible judgment calls of the economists at the helm of the economy are going to be more accurate than a mathematical model. Such arrogance, thinking that one can run an economy from the top, is typical of those in power positions. Of course, we should be as equally quick to point out that a mathematical model, which naturally originates in the mind of some other academician, is not any better. Central planning is central planning, whether we are told we ought to put faith in the model or in the discretion of the Central Planner.
Fed Chair Janet Yellen chose a politically popular topic: gender issues and discrimination in the workplace. She expressed frustration that discriminatory tendencies were holding back women's pay, apparently unaware that she could help by not being so adamant about increasing their cost of living. If one wonders what this has to do with monetary policy, it must be remembered that the Fed has to play the PR game, just like everyone else in bureaucratic positions.
John Williams of the San Francisco Fed came next. He was enthusiastic about the falling unemployment levels, not once mentioning either that people are taking on more part time jobs to stay afloat or that the employment participation rate itself is terribly low (the denominator in the employment calculation).
However, he expressed concern that job growth was actually growing too fast, as in Keynesian land too many people employed could be a sign of an overheating economy that should be slowed. Here is a piece by Christopher Casey challenging this alleged "Phillips Curve" conundrum.
Finally, St. Louis Fed's James Bullard touched on the balance sheet issue, opining that the Fed should start to roll back its holdings later this year. Whereas other Fed members want one more rate hike before touching the balance sheet, Bullard indicates that the interest rate levels are fine. The balance sheet is ready for "normalization!"
Bullard, however, is not a voting member of the FOMC so it remains to be seen whether any of the others will share his strategy.
FOMC Keeps Rates Steady
At 2:00 pm Eastern, the FOMC made their policy announcement as their meeting came to an end. As expected the Fed did not raise the Federal Funds rate target at this May meeting.
Two items are in focus now, however. The first is the possibility of a June hike. As always, the Fed wants be clear that such a move is “on the table.” Prior to the meeting, the June hike probability was around 70% and have now jumped to 90%. These odds will adjust over the rest of the week in response to the FOMC statement and the plethora of Fed member speeches this Friday. While the Fed doesn’t want to stick hard and fast to a timetable of their hikes, they do seem to be dedicated recently to appearing reliable. They said they’d aim for 3-4 hikes this year. Though of course as Thorten Polleit points out this morning, they will likely chicken out. FOMC on rate hikes:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
The second is the balance sheet issue. This has been the theme recently as the Fed is giving the impression that policy normalization is on the horizon. That is, the Fed alleges that it has the wherewithal to actually trim its $4.5t balance sheet. Normalization would take it back below $1t, at least. Yeah right. Nevertheless, the minutes of this May meeting will be released on May 24th and we will have a better idea at that time as to how in depth they covered this issue. Here is the FOMC on the balance sheet:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
These policy decisions come on the back of the lowest GDP growth rate in 3 years. And yet, the FOMC announcement did reveal they are positioning the GDP situation and other "soft data" weakness as "transitory." This means that it is not the mark of new economic problems, just sort of an outlier. But knowing the Fed, when push comes to shove, the only thing they know how to do is suppress interest rates and increase the money supply.
In sum: nothing new here!
FOMC Minutes: Continued Talk of Balance Sheet Strategy
The minutes from the March FOMC meeting were released yesterday and we discover that the balance sheet theme is really coming together. The massive portfolio held by the Fed is allegedly going to be reversed over the coming years. The way to initiate this shrinkage in the balance sheet is to first stop reinvesting the return that it is making on all the bonds it holds. In the minutes, we learn that they are considering two options for how to do this:
An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.
Option 1: "gradual" phasing out of the level of reinvestment. Option 2: immediate halting of any reinvestment whatsoever.
These are going to be the debated options moving forward in the coming FOMC meetings and Fed members speeches. The Fed tends to prefer "gradual" approaches to things, keeping at the forefront of their mind the possible reactions (temper tantrums) by stock and bond market participants. If they decide to begin phasing out reinvestment, it will be much later this year. This gives them two quarters in the meantime to conduct two more rate hikes.
The FOMC minutes give the suggestion that, as they try to get back to "normal" interest rates and balance sheet levels, they will be going back and forth between their two methods: Fed Funds rate hikes and slowing reinvestment. While watching paint dry has been more exciting than their rate hike progress, it seems that the Fed is going to be another two years before they get the Fed Funds rate into the 2% range (if they can make it that far) if they alternate between a reinvestment policy change and a Fed Funds hike.
Of course, all this could come unraveled by a single poor employment report. The wizards determining the direction of our economy, are actually as blind as anyone else. They are walking on eggshells, unsure what to do and where to go next. How does one reverse an 8-year 400% increase in the central bank's balance sheet without causing a commotion? That would be impossible.
Fed Financial Statements: $6 Billion Drop in Fed Remittances
As the Fed continues to increase the rate of interest it pays on excess reserves, the Fed's profits that are left over are slowly going to shrink in size. Since the Fed sends its profits to the US Treasury each year, the US Treasury will be receiving less. The Wall Street Journal reported on Friday:
The Federal Reserve sent $91.5 billion in profits to the Treasury Department last year, a $6 billion decline that officials have long expected as a result of rising interest rates.
The Fed’s total net income declined by $7.6 billion, to $92.4 billion, according to the Fed’s audited financial statements released Friday. The decline was primarily the result of higher interest payments it made to banks on the reserves they keep at the central bank.
David Howden has explained this process — and the implications for "Fed independence" — rather nicely:
Each year, the Fed remits to the US Treasury its net income, and thus provides the federal government with an important source of funding.
For the US Treasury, Fed remittances are something of a free lunch. When someone buys a Treasury bond, the government must pay them interest. This applies to the Fed as well, but then at year-end the Fed remits the interest back to the Treasury.
As much as economists talk about the independence that the Fed holds from Congress, these remittances represent a strong link. In fact, since they enable federal spending they create a form of quasi-fiscal policy for the Fed to use, in addition to its more common monetary policy options.
The slowly decreasing profits remitted to the Treasury each year is going to have implications for the increasing tension between the Trump administration and the Fed. If Trump wants to get his tax cuts through, he's going to need all the revenue help he can get. It may be even worse:
The payments are likely to shrink in the coming years as the Fed raises short-term interest rates—a process that involves paying banks higher interest on reserves they keep at the Fed—and when it eventually shrinks its balance sheet. Fed economists estimate the payments will fall to around $40 billion annually by 2020 but would likely rebound to about $65 billion a year by 2025.
A $40 billion payment in 2020 is less than half this year's $91.5 billion payment, which means that, assuming today's budget levels there's a massive $50 billion drop in revenue for the Federal Government, all things equal. Of course, spending goes up every year and so by 2020, who knows what may happen.
In the meantime, will the Fed eventually be "forced" to reverse course on interest rates to put a band-aid on the absurd Federal budget?
Fed Ready to Hike Rates? Where They Stand.
Talk of the Fed's upcoming FOMC meeting, which takes place March 14–15, has largely been centered around the prospects of a rate hike — with a plethora of Fed members coming out with a hard "hawkish" push. Here is a round up of their recent comments.
We currently judge that it will be appropriate to gradually increase the federal funds rate if the economic data continue to come in about as we expect.
So, put it all together, I think the case for monetary policy tightening has become a lot more compelling ... sooner rather than later.
Assuming continued progress, it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path.
We want to guard against a situation where we get behind the curve on inflation.
If there has been a conscious effort [to hike in March] I’m about to join it. ... I think the advice that has been given by a large number of members of the Fed, of the [FOMC], is correct, and I strongly support it.
Seeing any data that is not consistent with what I see as continued growth in the economy. We'll see. But I don't think March should be taken off the table at this point.
The case for a rate increase in March has come together.
I'd be comfortable, if the economy continues on, for interest rates to be higher than they are now.
Richmond Fed President Jeffrey Lacker. (Referring to the idea that the Fed should hike to avoid inflationary pressures):
Monetary policy in the 1960s makes for a sobering tale, but I believe we can avoid repeating those mistakes.
In my view, a rate increase is very much on the table for serious consideration at our March meeting. We need to gradually ease our foot off the gas in order to avoid a 'too hot' economy that in the end isn’t sustainable.
St. Louis Fed President James Bullard was the only major dissenter of the above hawkishness:
I wouldn’t see any reason to be especially aggressive about interest-rate hikes in this environment.
What actually ends up happening remains to be seen. Next week is the final week before the March meeting. Anything can happen and we will be sure to report on any changes in the narrative.