6 Major Flaws in the Fed's Economic Model

08/15/2014 09:55
James Rickards
by James Rickards

The U.S. dollar is the dominant global reserve currency. All markets, including stocks, bonds, commodities, and foreign exchange are affected by the value of the dollar.

The value of the dollar, in effect, its "price" is determined by interest rates. When the Federal Reserve manipulates interest rates, it is manipulating, and therefore distorting, every market in the world.


The Fed may have some legitimate role as an emergency lender of last resort and as a force to use liquidity to maintain price stability. But, the lender of last resort function has morphed into an all-purpose bailout facility, and the liquidity function has morphed into massive manipulation of interest rates.

The original sin with regard to Fed powers was the Humphrey-Hawkins Full Employment Act of 1978 signed by President Carter. This created the "dual mandate" which allowed the Fed to consider employment as well as price stability in setting policy.

The dual mandate allows the Fed to manage the U.S. jobs market and, by extension, the economy as a whole, instead of confining itself to straightforward liquidity operations.

Janet Yellen, the Fed chairwoman, is a strong advocate of the dual mandate and has emphasized employment targets in the setting of Fed policy. Through the dual mandate and her embrace of it, and using the dollar's unique role as leverage, she is a de facto central planner for the world. Like all central planners, she will fail. Yellen's greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that do not correspond to reality. This approach is highlighted in two Yellen speeches. In June 2012 she described her "optimal control" model and in April 2013 she described her model of "communications policy."

"Yellen's greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that do not correspond to reality."
The theory of optimal control says that conventional monetary rules, such as the Taylor Rule or a commodity price standard, should be abandoned in current conditions in favor of a policy that will keep rates lower, longer than otherwise. Yellen favors use of communications policy to let individuals and markets know the Fed's intentions under optimal control.

The idea is that over time, individuals will "get the message" and begin to make borrowing, investment and spending decisions based on the promise of lower rates. This will then lead to increased aggregate demand, higher employment and stronger economic growth.

At that point, the Fed can begin to withdraw policy support in order to prevent an outbreak of inflation.

The flaws in Yellen's models are numerous. Here are a few:
  1. Under Yellen's own model, saying she will keep rates "lower, longer" is designed to improve the economy sooner than alternative policies. But if the economy improves sooner under her policy, she will raise rates sooner. So, the entire approach is a lie. Somehow people are supposed to play along with Yellen's low rate promise even though they intuitively understand that if things get better the promise will be rescinded. This produces confusion.
  2. People are not automatons who mindlessly do what Yellen wants. In the face of the embedded contradictions of Yellen's model, people prefer to hoard cash, stay on the sidelines and not get suckered by the bait-and-switch promise of optimal control theory. The resulting lack of investment and consumption is what is really hurting the economy. Economists call this "regime uncertainty" and it was a leading cause of the length, if not the origin, of the Great Depression of 1929-1941.
  3. In order to make money under the Fed's zero interest rate policy, banks are engaging in hidden off-balance sheet transactions, including asset swaps, which substantially increase systemic risk. In an asset swap, a bank with weak collateral will "swap" that for good collateral with an institutional investor in a transaction that will be reversed at some point. The bank then takes the good collateral and uses it for margin in another swap with another bank. In effect, a two-party deal has been turned into a three-party deal with greater risk and credit exposure all around.
  4. Yellen's zero interest rate policy constitutes massive theft from savers. Applying a normalized interest rate of about 2% to the entire savings pool in the U.S. banking system compared to the actual rate of zero, reveals a $400 billion per year wealth transfer from savers to the banks from the zero rates. This has continued for five years, so the cumulative subsidy to the banking system at the expense of everyday Americans is now over $2 trillion. This hurts investment, penalizes savers and forces retirees into inappropriate risk investments such as the stock market. Yellen supports this bank subsidy and theft from savers.
  5. The Fed is now insolvent. By buying highly volatile long-term Treasury notes instead of safe short-term treasury bills, the Fed has wiped out its capital on a mark-to-market basis. Of course, the Fed carries these notes on its balance sheet "at cost" and does not mark to market, but if they did they would be broke. This fact will be more difficult to hide as interest rates are allowed to rise. The insolvency of the Fed will become a major political issue in the years ahead and may necessitate a financial bail-out of the Fed by taxpayers. Yellen is a leading advocate of the policies that have resulted in the Fed's insolvency.
  6. Market participants and policymakers rely on market prices to make decisions about economic policy. What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation, then you rely on the "price" to guide your policy going forward. This is the blind leading the blind.

The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run. But once you change the psychology, it is extremely difficult to change it back again.

If the Fed succeeds in raising inflationary expectations, those expectations may quickly get out of control as they did in the 1970's. This means that instead of inflation leveling off at 3%, inflation may quickly jump to 7% or higher. The Fed believes they can dial-down the thermostat if this happens, but they will discover that the psychology is not easy to reverse and inflation will run out of control.

The solution is for Congress to repeal the dual mandate and return the Fed to its original purpose as lender of last resort and short-term liquidity provider.

Central planning failed for Stalin and Mao Zedong and it will fail for Janet Yellen too.


James Rickards is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestseller Currency Wars, published in 2011. 2014 Laissez Faire Books, LLC. This article originally appeared here