By Axel Merk
While Democrats and Republicans fight with water pistols, the President may be readying a bazooka by nominating Janet Yellen to succeed Ben Bernanke as Fed Chair. You may want to hold on to your wallet; let me explain.
Our reference to water pistols refers to our assessment that bickering over discretionary spending is distracting from the real issue, entitlement reform. For details as to what we believe will happen if we don’t get entitlement reform done, please read our recent Merk Insight “The Most Predictable Economic Crisis”.
Central banks in developed countries are generally considered independent, even if their members are appointed by politicians. In the U.S., however, there’s an added element: aside from a mandate for price stability, the Federal Reserve is tasked with promoting maximum sustainable employment. This simple concept might have been put in place with the best of intentions – who wouldn’t want to have maximum employment? Central banks that have a single focus on price stability, such as the European Central Bank, point out that the best way to foster sustainable growth is by keeping inflation low. The U.S., even with an employment mandate, had pursued the same practice.
That is, until Ben Bernanke appeared to run out of options to lower borrowing costs. Bernanke’s frame of reference had been the Great Depression; he had frequently cautioned that the biggest mistake during the Great Depression was to raise interest rates too early. After a credit bust, as central banks push against deflationary market forces, premature tightening might undo the progress to reflate the economy. In today’s world, it’s not just short term, but also longer-term interest rates that Bernanke has been concerned about – partially because Bernanke has always considered it important to keep mortgage rates low. To achieve his goal, the Bernanke Fed:
Talked down interest rates;
Lowered interest rates;
Purchased Treasury and Mortgage-Backed Securities
Engaged in Operation Twist
Introduced an employment target
Introducing an employment target was nothing but an extension of existing policies, as it signals the Fed might keep rates low independent of where inflation might be.
With Janet Yellen coming in, the concept of promoting employment is raised to a new level. Long gone is the Great Depression, but what remains may be a conviction that monetary policy should make up for the shortfalls of fiscal policy. That’s problematic for a couple of reasons:
When the Fed meddles with fiscal policy, Congress will want to meddle with monetary policy. For example, when the Fed buys mortgage-backed securities it allocates money to a specific sector of the economy (favoring the housing market); that’s not what the Fed ought to do – it’s the role of Congress to channel money through tax and regulatory policy. One can disagree whether even Congress should be picking winners and losers in an economy, but that’s a political determination to be made by elected officials.
(For the rest of the article, click the link.)