“Before the 15th century, people gazed at the sky, and believed that other planets would move around the Earth, stop, move backwards for a bit, and then move forward again. Their model of the world – that the Earth was the center of the universe – was the source of this confusion,” writes John Hussman, president of Hussman Investment Trust, at the beginning of his broadside attack on Federal Reserve policy that questions whether the Fed even understands how the economy works. “One of the reasons that the economy seems so confusing at present is that our policy makers are following models that have very mixed evidence in reality.”
The model that the Fed is using, Hussman argues, is one where increasing the monetary base relative to GDP lowers short-term interest rates; lower short-term interest rates stimulate economic activity and job creation; general price inflation won’t kick in until we get real wage inflation; and that QE is benign absent general price inflation.
While he doesn’t disagree with each piece of this worldview on its own, taken together he sees it as the foundation for years of harmful Fed policy.
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Low rates haven’t spurred economic activity job growth, says Hussman
The first part of this chain, that increasing the monetary base lowers rates, is true but according to Hussman beside the point. Calling it one of the strongest economic relationships in the real world, he argues that the Fed isn’t wrong in principle but it has jacked up the monetary base so much that any possible benefit would have long been realized.
The problem is that these low rates haven’t translated into a dynamic economy. When a company considers whether it wants to make an investment the cost of money is part of the calculation, but only part – there have to be attractive investment opportunities in the first place. If there aren’t that many ways to put capital to productive use and the cost of money keeps falling, he says that the all the excess cash will be put to use by financial engineering and other speculative activities where the cost of money is the primary consideration. Tracking economic growth versus either interest rates or real rates, it’s clear that the correlation is extremely loose, so it’s not that surprising that it doesn’t seem to hold right now.
“So what we now have is a financial sector amped up on more than four trillion tablets of amphetamine, and a real economic sector that remains at year-to-year growth rates that have historically marked the border between expansion and recession,” Hussman writes.
Fed policy conflates wage growth with price inflation, says Hussman
If Fed policy was simply ineffective Hussman might not be so vocal, but he also believes that it is undermining the country’s eventual economic recovery. Federal Reserve chair has made it clear that as long as inflation remains under control she will continue to pursue a stronger labor market, in line with the Fed’s dual mandate, but according to Hussman the Fed is conflating wage inflation with general price inflation.
The Phillips Curve, proposed by A.W. Phillips in the 1950s, is basically another formulation of supply and demand that says lower unemployment should cause greater wage inflation. The correlation is noisy, but it still shows up in US data.
But the same correlation doesn’t exist between unemployment and general price inflation, either of which can move independently of the other, so it’s entirely possible that price inflation will grow without seeing any improvement in wage inflation.
Meanwhile productivity gains have been moderate and labor gains have been nearly non-existent, a disparity that Hussman blames on misallocations of capital to the financial sector from the rest of the economy, resulting in a “winner-take-all economy”.
Hussman doesn’t have any quick alternatives to spur wage growth or labor participation, but he see QE induced speculation pulling cash away from more productive long-term capital allocations. Maybe it’s not surprising that the man best known for calling the 2007-2008 collapse is calling another bubble, but if he’s write then last year’s bull run didn’t just get ahead of the economic recovery, it stepped in the way.
“The issue is not whether the U.S. economy does or does not need ‘life support’,” he writes. “The issue is that QE is not life support in the first place.”