Central Bankers Don’t Know Any More Than the Rest of Us

“Your faith that central bankers know “where they are” is a little surprising (“Central banks correctly go their separate ways”, editorial, June 16). Since the crisis nadir, inflation and growth outcomes have consistently fallen short of what was expected by the central bankers of major market economies despite an unprecedented period of low policy rates alongside outsized balance sheets. Current policy may be moving in different directions for reasons that seem logical today but the reality is that no one knows how smooth or bumpy the path will be from this point forward.”

Quin Casey, Letter to the Editor, Financial Times, June 22, 2018

 

Jerome Powell, our new Federal Reserve Chairman replacing Janet Yellin, delivered a revealing speech to the European Central Bank Forum in Portugal recently.

The speech is illuminating and important because it shows how out of touch our central bankers are with the economy. It is stunning to see statements of purported fact followed by another that contradicts it. Equally baffling, the Chair does not seem to be aware of the information released in the most recent Employment Situation, the official government report on employment released monthly by the Bureau of labor Statistics, (BLS)

For example, first statement:

“Today, most Americans who want jobs can find them.”

Next statement:

“High demand for workers should support wage growth and labor force participation–the latter a measure on which the United States now lags most other advanced economies.”

Yes, high demand for workers should promote wage increases, but it wages have barely increased in the last decade. The BLS data contained in The Employment Situation tells us that wages have risen only 2.7% in the last year.  According to Trading Economics, wage growth has been declining since 1979 and now is about as low as it ever has been. There does not seem to be any pressure on wages at all.

So, no, there hasn’t been any wage growth, bringing into question whether there really is a high demand for workers.

What about labor force participation?

Trading Economics shows that labor force participation is now about what it was in the late 1970’s when women were just beginning to enter the labor force. Again high demand for workers would draw people back into the labor market, but that does not seem to be happening. Powell seems to have some understanding of this because he points out that our labor force participation rate is lower than other industrialized economies with which we compete.

A little later in the speech, another contradiction…

First sentence:

“As is often the case, in the current environment, significant uncertainty attends the process of making monetary policy.

Note the term “significant uncertainty”.

The economy is not recovering. Saying that it does implies that we are going back to something like what we had before, Things have changed so much that it is more accurate to say that we are building a brand new economy. That is why there is “significant uncertainty” – old concepts and metrics don’t work in the emerging economy as they did in the old industrial economy.

For example, there is the “Phillips Curve” that measures the relationship between employment and inflation. As people go back to work following a recession, they have more money, creating demand, which causes prices to increase. That is why a little inflation is a good thing.

However, unemployment is at 3.8% and there is little sign of inflation, implying that people don’t have enough money to create a demand strong enough to fuel inflation, even though they count as employed. That might be because of low wages in the gig economy.

Contingent workers make a lot less than people do in traditional jobs. We don’t know what the effect of contingent labor market has on other parts of the economy because we haven’t figured out a way to measure contingent employment.

Second sentence:

“Today, with the economy strong and risks to the outlook balanced, the case for continued gradual increases in the federal funds rate remains strong and broadly supported among FOMC participants.”

Powell sounds very confident in light of his previous comment about the significant uncertainty supporting monetary policymaking.

Finally, this:

“Unfortunately, with the passage of a half-century and important changes in the structure of our economy and in central bank practices, in my view the historical comparison does not shed as much light as we might have hoped.”

Here he mentions “structure”. Structural changes in the economy mean permanent change, not just normal cyclical changes.

Examples of this might be the end of mass employment in industry. It’s not that industry has left the United States; there is more than ever right now. It’s just that robots and software do most of the work.

The shift of traditional well-paying 40 hour a week jobs to low paying contingent employment is another example. Now we have to remember that just because someone has a job does not mean they can afford food and shelter.

So why is Powell running in circles? Reading between the lines, as we have been doing here, reveals a much different picture than taking the speech at face value.

I’ve been a little harsh on him, really. He’s in a tough position. The integrity of the banking system has as much to do with perception as reality. When people stop having faith in the financial health of a bank, they withdraw their money. When people see others withdrawing money the safety of their deposits come into question and they are inclined to withdraw as well. This is what a “run on the bank” is – panicked withdrawals that may or may not be necessary.

When this happens to one bank, people tend to lose faith in all banks. This is what social psychologists call “social proof”. This is one of many heuristics, or shortcuts to decision making. When we see many other people doing a particular thing we tend to trust their judgment and join in, usually without thinking.

James Surowiecki has written a wonderful book about heuristics in economics and finances, (and many other settings), in his book Wisdom of Crowds. I highly recommend it.

It may come as a surprise, but banks do not have enough cash on hand to cover all their debts to customers. Deposits go out the door in the form of loans, or during the collapse of the industrial economy in 2008, in the form of loans to other banks buying blocks of risky home mortgages. This is where the Federal Deposit Insurance Corporation (FDIC) and central banks, like the Federal Reserve come in.

The FDIC insures consumer deposits for up to $250,000 and central banks stand by to infuse troubled banks with huge amounts of cash to forestall a run and maintain faith in the banking system.

This is why Chairman Powell has to be so careful about what he says. On the one hand, he can’t just make outright falsehoods about the economy because the first time someone catches him in a lie will be the last time anyone believes him. He can’t be brutally honest about the economy, either, without undermining faith in the future.

So you have to listen carefully, take note of what he does not say, and examine exactly what he does say. Powell is saying that things are better than they were, we aren’t sure why, and we’ll move ahead cautiously.

But bank customers aren’t the only ones for whom Powell is designing his messages. He is the Chair of the Federal Reserve and one of 11 members of the Feds Board of Governors. The Federal Reserve consists of 12 of the largest banks in the United States.

The Board of Governors are the presidents of those banks and they creates monetary policy as a group. Most of their influence lies in inter-bank standards, like how much interest these banks charge one another, and agreements on length and volume of bond sales.

Remember Qualitative Easing? That was when the Fed was buying back bonds. Bonds are debt instruments – when you buy a bond you are loaning money to the bond issuer. Buying back Treasury bonds – like savings bonds except a lot bigger—is a way for banks to shed debt, but it also a way to pump money back into the economy.

For more than a year following the crash of 2008, the Fed was pumping $80 billion a month into the economy. It was the only thing keeping the economy solvent.

Yes, things were that bad.

You can read all about it in Mohamed El-Erian’s detailed and very readable account of the 2008 financial crisis, The Only Game in Town.

The challenge for Powell as Chair of the Fed is to get all 12 members of the Fed to agree on monetary policy. It sounds like dull and boring issues to most of us, but members of the Federal Reserve are passionate about economics – they all have PhDs from leading universities – and they are very ambitious and driven.

Powell has to get these all people to agree on specific and detailed monetary policy. Think about the last time you tried to get a few of your friends to decide on where to go for lunch or dinner. That’s hard enough.

Getting intelligent, personally ambitious and driven people to agree with one another is a herculean task. Getting them to agree on something the President supports and Congress might tolerate compounds the challenge, but this is at the core of Powell’s job description.

So no, the Fed chair can’t just make outright lies, but he can’t be brutally honest either. He has to construct a narrative that fits the facts and doesn’t get anyone upset while using data that is incomplete and uncertain.

That is why it is so important to listen carefully to what he says, and look for nuance and veiled meaning. It is also important to remember that the Federal Reserve doesn’t know everything. As Powell tells us repeatedly, we are in an entirely new emerging economy and there is “significant uncertainty”.

After all central banks don’t know any more than anyone else.

 

Sources used in this article:

El-Erian, M. A. (2017). The only game in town: Central banks, instability, and avoiding the next collapse. New York: Random House.

Surowiecki, J. (2004). The wisdom of crowds: Why the many are smarter than the few and how collective wisdom shapes business, economies, societies, and nations (1st ed.). New York: Doubleday.

 

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