Recently, the Federal Reserve Bank (Fed) suggested a less accommodative monetary policy may be in the offing. Translation: an end to quantitative easing (QE), which implies less available liquidity (money and credit) in the market.
Along with this pronouncement, the Fed issued the following prognostications:
Time Real GDP(Annual Growth) Inflation(Annual) Unemployment
2011 3% 2.5% 8.8%
2012 election 4% 1.5% Under 8%
Long Term 2.5% Under 2% 5.5%
The 2012 election data is unrealistic, while those for the long term defy economic gravity.
The former anticipates real GDP, unemployment, and inflation to improve by one percentage point each (highly suspect). The latter suggests a large employment increase accompanied by lower economic growth and less inflation. At best, this represents a marked decline in labor productivity: an ominous scenario, indeed.
In 1978, President Jimmy Carter signed the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978. This legislation mandates the Board of Governors of the Federal Reserve to implement monetary policy to maintain long-term growth, minimize inflation, and promotes price stability.
It seems this legislation attempted to deflect responsibility of prudent economic policies to the Federal Reserve Board, an entity comprised of unelected, unaccountable individuals and entities, both private and public.
Monetary policy affects the money supply, not monetary velocity. Velocity (economic multiplier) measures the turnover of the money supply. It is the velocity, or turnover, that ultimately drives economic growth and prosperity.
After 30 years, the Fed may need to re-evaluate this misappropriated mission.
Monetary velocity has been anemic in recent years. The reasons: high unemployment, low income, and an enormous supply of artificially inflated assets, financial and real. Sales of these assets have reduced prices and debt to more manageable levels, commensurate with true demand based on income and value added productivity.
Economic growth thrives in a stable, fair, and competitive environment. This liberates entrepreneurs and businesses to monetize their innovative creations.
The environmental template provided by government over the past few decades was antithetical to this premise. Instead, it enabled a pathological metastasis of irresponsible, unaccountable, capitalistic excess.
In fact, this administration has implemented policies that further exacerbate the underlying causes of the financial crisis.
The government functions best when it acts as an arbiter to protect individual liberties, creation, and innovation. The administration has it reversed. It is attempting to empower government as the creator and innovator. Historically, this hasn't occurred, and probably never will.
To wit, the massive federal expenditures, which created enormous debt, have been used to employ more government workers.
Recently, unemployment has decreased slightly due to a rise in government hiring. The Bureau of Labor Statistics (BLS) reported the national rate for March 2011 was 8.8 percent, while that for government was only 3.9 percent. In addition, education and health services, areas heavily subsidized by government expenditures, had a 5.2 percent unemployment rate, also well below the national average.
Dr. John Taylor of Stanford University suggests the velocity for the public-sector expenditures may be less than half that for private industry. Therefore, these expenditures may not provide society with a reasonable return on investment.
Back to the Fed’s real mission: price stability
Estimates suggest the official inflation figures, used by the Fed to create policy, have been underreported during the past 20 to 30 years by one-third or one-half. Lower inflation translates to greater real economic growth, a more politically palatable construct.
In addition, the Federal Reserve Board focuses on the “core inflation” rate, which excludes food and energy. This is antithetical, since food and energy form the core of our existence: without these commodities, we die.
The inflation methodology that is used to understate inflation include: commodity substitution, hedonic quality adjustments, owner equivalent rent, and the use of geometric mean in the calculation.
Commodity substitution involves substituting less-expensive items for more costly ones in the “consumer commodity basket.” For example, they might replace steak with hamburger.
Hedonic quality adjustments involve reducing the price of an item by removing the additional quality enhancements. This conveniently ignores economic reality. Many of these quality improvements are standard to the product, and the cost of inclusion may be less due to effective economies of scale. For instance, the price of an automobile may be reduced by eliminating the cost of its air conditioner.
Owner equivalent rent eliminates price appreciation due to investment demand. This explains why the inflation figures were rather low from 1994-2006 as real-estate prices exploded. Investment demand needs to be considered. For a property owner to realize a normal return on investment, this additional cost will ultimately be reflected in the supply price for the purchaser of housing (whether for consumption or investment).
Lastly, the geometric mean provides additional weight to those commodities that increased less in price over the given time frame. Rather than comparing the cost of the entire basket at different times, this measure calculates the price increase of each commodity and multiplies them together. In essence, a fraction multiplied by a fraction generates a smaller fraction. For example, one-half multiplied by one-half equals one-quarter. Therefore, the true price increase of the basket is reduced.
Nearly one year ago, I expressed agreement with Thomas M. Hoenig, President of the Kansas City Federal Reserve Bank. At that time, he was the only Fed member to recommend a more restrictive monetary policy. This implies a reduction in the growth of money and credit with an increase in interest rates.
I believe a tempered, incremental increase in interest rates would provide the proper market incentivizes to exchange monetary aggregates. It would be based on the realistic assessment of innovative and creative ideas that add sustainable value to society.
This financial foundation would energize and reframe the economic environment into one that appreciates real value, real products, and a real return on investment.
We have been fed enough by the Fed.
Let's get back to work, America!
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