Fed Assumptions Have Helped the Wealthy but Not Employment, Productivity

Government has gone by the false belief that a low interest rate is best for the long-term health of the U.S. economy.
By John Mason ,

The Federal Reserve has an inflation target of 2%. This is one of two major drivers of Federal Reserve policy-making as it considers an interest rate hike.

But the 2% goal is deceiving. It suggests that employment and economic levels are stronger than they are. The reality is declining workforce participation and capacity utilization. The latter is a closely followed measure of manufacturing health. Fed policy as mandated by the U.S. government has done more to help the wealthy than everyone else. 

The Federal Reserve assumes that there is a tradeoff in the economy between the inflation and unemployment rates. Economists capture this tradeoff in something called the Phillips curve, named for New Zealand economist, William Phillips

The Phillips curve shows that employment and higher inflation rates are interconnected. 

Too much inflation is bad, so the Fed choses 2% because it is not too high or too low. If the Fed hits its 2% inflation target, the Phillips curve says that there will be a lower rate of unemployment than it would achieve otherwise. That is good. The congressional mandate under which the Fed operates requires government to achieve high levels of employment, or low levels of unemployment.

But a byproduct is that the Fed ensures a high rate of return for the informed, sophisticated investor, namely wealthy individuals who know how to take advantage of low interest rates. 

To achieve the tradeoff between unemployment and inflation, Phillips assumed that the inflation that occurs is "unanticipated" -- the investor does not expect the inflation to occur. So the tradeoff is achieved by deception.

Milton Friedman, Nobel-prize winning economist, says that this tradeoff can only be a short-term phenomenon. Investors may be fooled at first, but then they learn what the government is trying to do. Friedman states that once this occurs, the unemployment/inflation tradeoff will disappear. Therefore, in the longer run, the tradeoff does not exist.

This does not stop politicians. Promising lower unemployment is a staple election pledge. 

Nobel-prize winning economists George Akerlof and Robert Shiller explain this in a new book entitled Phishing for Phools.

Akerlof and Shiller argue that because phish want to hear what they want to hear and phishers offer the right bait, a transaction can occur. In other words, if phish bite at the right bait repeatedly, phisshers, such as politicians, can feed them the same old thing.

A number of Harvard professors and other experts have said that the Phillips curve can support the unemployment/inflation tradeoff. The government works hard to ensure the right inflation level so that unemployment is lower than it would be otherwise.

According to Milton Friedman's analysis, as informed, sophisticated investors learn more, the unanticipated inflation rates become anticipated. It's easy to expect that the sophisticated, informed investor will do all that he or she can to take advantage of the overall situation. That is, these investors will look to gain as much financial leverage as possible. The returns are substantial enough that they can use all kinds of financial innovation to achieve their goals.

Akerlof and Shiller racount how phishing for phools played in all the securitization that occurred over the past four decades. This includes derivative instruments that were created, even when risk was not totally understood or accounted for because information was lacking or skewed. In other words, many people did not understand what they were getting into.

Furthermore, the nature of the financial industry changed as trading, not intermediation, became the source of profit, and highly trained quants replaced financial professionals more focused on building relationships. Rather than finance contributing to the production of goods and services, finance dealt primarily with finance. John Kay writes about this environment in Other People's Money.

The point is that having an inflation target unleashed talent and resources to take advantage of the inflation target, and the latter profited greatly.

But, as Akerlof and Shiller state, "The sophisticated/informed almost always do better than the naive/uninformed. Whenever that occurs there is phishing for phools."

It has taken the U.S. economy and financial system about 55 years to get to this point. Policy expectations cannot be undone overnight. Probably only the top 10%, maybe less, of the wealthy have benefitted from the Phillips curve.

Unfortunately, others have not as the labor force participation rate declines to where it was in the 1970s, and the underemployed who want to work can't find full-time jobs. Capacity utilization is under 80%, down from over 90% in the 1960s. A lot of resources, human and physical, remain idle.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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