One of the things I always try to remember is that government employees (and this includes the folks at the Federal Reserve) are people just like you and me, most of whom work very hard to do what they believe is right.
The Fed is often maligned, sometimes unfairly. No matter what it does, it’s going to be criticized, often loudly, by someone.
So I don’t think Chicago Fed President Charles Evans is a bad person… just a very wrong person, one of the wrongest people on earth, when he says that it would be a “catastrophe” if the Fed raised rates.
It would not.
First, a Little Background
Evans has been in the top job since 2007 and has been a creature of the Chicago Fed for many years. He’s a trained economist with a PhD from Carnegie Mellon (a “freshwater” school). He’s very accomplished, with a long list of publications in respected journals. He arguably knows more about central banking than I do, me being some dude living in South Carolina with an MBA from a third-tier school, but at least I got an A+ in my macroeconomics class.
While not as dovish perhaps as Rosengren or Dudley (or especially Kocherlakota), Evans has always been a reliable dovish vote on the Federal Open Market Committee (FOMC). He’s also a pretty good indicator of which way the political winds are blowing at the Fed, so when he says it would be a “catastrophe” if the Fed raised rates, he speaks not just for himself, but many other members of the FOMC.
This is where I dust off my third-tier MBA and go back to 2002, when I was a trader at Lehman Brothers.
As you might imagine, as an index arbitrage trader with an $8 billion balance sheet that I was funding on an overnight basis, I cared very much about short-term interest rates. I spent a lot of time trying to figure out what the Fed was going to do. Back then in 2002, there was a general rule of thumb that if the NAPM (now ISM) was above 50, the Fed would be hiking.
Well, right now the ISM is well above 50—and has been for a while—and the Fed is not hiking.
GDP growth is also 5%.
Unemployment is 5.6%, and we’ve had solid job growth for years.
Pretend it’s 2004. I give you these numbers, and I ask you what you think the Fed is going to do. Naturally, you’re like, “They’re ripping rates higher.”
Au contraire. They are not. Evans (and others) want to let the economy run hot.
The Curious Case of New Zealand
If you know a little about New Zealand’s economic history, you know it had a pretty massive inflation problem, like most of the developed world in the 1970s. But its politicians devised a very effective way of dealing with it: the inflation target.
Inflation targeting was once a very controversial central banking technique. Not anymore. Basically, New Zealand said, “We want inflation to be 2% instead of 10%,” or whatever it was. So the government tightened monetary policy and didn’t stop until inflation reached the 2% target.
None of this wishy-washy discretionary Greenspan stuff. They just cranked on rates until inflation was fixed.
Funny thing about inflation targets is they work in both directions. Like if inflation is under 2%, you ease monetary policy until it gets back up there. That’s kind of what’s going on right now in the US and elsewhere.
But the Kiwis just chose the 2% number randomly. Like, “2% sounds like a good idea, so let’s go for that.” But there wasn’t any empirical reason to choose that number. It was arbitrary.
The New Inflation Target
So central banks are looking around and saying, “You know, maybe the 2% inflation target is too low. Maybe we should have something higher—like 4%.” And in fact, someone at the International Monetary Fund (IMF) recently published a working paper arguing for just that.
Only about 10 years ago, we actually had 4% inflation. It wasn’t that bad, right? Of course, we had 4% inflation on the way down from 14% to 2%, and path dependency is important.
The other thing I think people might not be thinking clearly about is that 4% inflation compounds very quickly. You would think that someone at the Federal Reserve would be able to drop this into Microsoft Excel and figure it out.
At 4% inflation, prices will double in 18 years. The Fed is supposed to be, above all, the guardian of our purchasing power.
I don’t think 4% inflation is very fun at all.
Nobody has talked explicitly about a 4% inflation target in the US, not even Evans. But he did say that it would not be a catastrophe if inflation were allowed to exceed the 2% target for a while. And Yellen has said something similar.
Yes, the Fed is actually trying to create inflation. And not just a little inflation. A lot.
A Little Inflation Is Fun
One thing the Fed doesn’t understand is state-dependent central banking. Let me put it this way: if we manage to create 4% inflation, the economy is going to be roaring. And post-financial crisis, people are really going to like what will be the first sustained economic boom in about 10 years.
Inflation is fun at the beginning. Then it becomes not so fun.
I was born in the middle of what would have been the Burns Fed, which by all accounts, is considered very unsuccessful. Arthur Burns liked inflation a little too much. And his successor, G. William Miller… well, that was a complete disaster.
These are black marks on the Fed’s history. Evans and many others think that they can control or even reverse inflation once it gets to 4%. They can’t and won’t. The political pressure not to do so will be enormous. A good way to prevent high inflation is not to screw around with low inflation.
A Fed economist would probably lecture me on the ills of deflation. Okay. Name one deflation, one liquidity trap, where there has been food or fuel shortages. Or riots. Or that has led to a world war. Your approaches to inflation and deflation should be asymmetrical, because inflation is far more dangerous.
With all due respect to Dr. Evans, I think it’s very irresponsible to say that raising rates even a single basis point would be a catastrophe. I think we’re sowing the seeds for far higher inflation 10-20 years in the future.
I also think now would be a
great time to take out a huge mortgage.
Jared Dillian
