Janet Yellen’s moment

By Anatole Kaletsky
March 18, 2014

When Janet Yellen chairs her first meeting of the Federal Open Market Committee Tuesday and Wednesday, she will be presented with a once-in-a-generation opportunity that even her predecessors in the world’s most powerful economic position have rarely enjoyed.

Not only can Yellen alter the guidance on interest rates with which the FOMC has been steering global financial markets. Beyond that she could do something far more profound and exciting: transform an entire generation’s way of thinking about economics, market forces and the role of government in achieving and maintaining prosperity.

To start with the obvious, Yellen will almost certainly change or simply abolish the unemployment “threshold” of 6.5 percent announced early last year as a reference point for the FOMC to start considering the possibility of higher interest rates — perhaps setting a threshold of 5 percent or so. More radically, she could supplement the objective of lower unemployment with a range of other indicators that will need to improve before the Federal Reserve even considers any monetary tightening: for example, accelerating gross domestic product growth; strengthening productivity trends and eliminating the excess capacity in many industries that is now discouraging investment, hiring and productivity growth, as well as holding down corporate pricing power.

This potential broadening of the range of monetary objectives suggests the really radical possibilities opened up by Yellen’s leadership of the Fed. Might she announce, for example, that as the economy recovers, the Fed will ignore accelerating inflation and focus entirely on promoting maximum employment, unless and until inflation exceeds some truly uncomfortable level such as 3 or 4 percent? Will she follow up on some of the work done within the Fed, suggesting that expansionary monetary policy can act not just as a cyclical stimulus, but could also improve supply-side conditions and long-term productivity growth?

Might she even suggest that, if the economy requires further monetary stimulus in future, Quantitative Easing could be coordinated with fiscal policy? For example, the Fed could print “helicopter money” for the government to “drop” directly on to the public via citizen dividends or per capita tax rebates.

Such radical ideas may be too much to expect from Yellen at this stage. But could we see a series of smaller shifts that gradually produce a monetary revolution?

To understand why the Ben Bernanke-Yellen transition could be so significant requires a brief detour into economic theory and history. In contrast to Bernanke, who was a lifelong apostle of monetarism and of Milton Friedman, Yellen has a Keynesian academic background. This may not be significant in terms of policy — since Bernanke already ventured far beyond traditional monetarist central banking — but the theoretical distinction could transform the Fed’s understanding of what it is doing and why.

In the five years since the 2008 financial crisis, central banks all over the world have, reluctantly and cautiously, begun an intellectual revolution. The failure of traditional economic theory to anticipate or explain the crisis — and the even more remarkable failure of traditional models and policies to chart the way back to normal economic conditions — has forced central bankers to re-examine some of the most fundamental tenets of modern economic theory. In the process they have started to question some of their core beliefs about the social purpose of central banking. These beliefs were always just theoretical hypotheses and assumptions, but were transformed into unquestionable dogmas by the great inflation of the 1970s and the resulting monetarist “counter-revolution” against Keynesian economics.

Three of these fundamental assumptions about monetary policy, and about government macroeconomic management more generally, have gradually been re-opening for debate around the world: First, that high inflation is the only monetary obstacle to satisfactory economic growth and employment — and therefore that controlling inflation is the sole legitimate long-run objective of monetary policy. Second, that political independence of central banks from governments must be protected at all costs — and therefore monetary policy must be managed separately from fiscal policy. Third, that monetary policy can have no permanent influence on an economy’s underlying productivity growth, employment levels or other “supply-side” conditions — and therefore a central bank has no role to play in a nation’s efforts to accelerate long-term economic growth, apart from maintaining price stability.

All these assertions about monetary policy were accepted in the 20 years before the 2008 crisis as scientifically-established laws of nature, because it was possible to invent theoretical models from which they could mathematically be derived. But neither the assumptions that produced these models, nor the conclusions they generated were supported by strong evidence from the real world.

For example, one key empirical “fact” that justified the 1980s consensus in favor of inflation targeting and independent central banks was an observation by Milton Friedman in the late 1960s, which supposedly proved that the “trade-off” between inflation and unemployment previously assumed by central bankers did not exist.

But Friedman’s empirical discovery, known as the “vertical Phillips curve,” supposedly showing that widely varying levels of inflation coincided with a single natural level of unemployment, subsequently turned out to be completely wrong. Actually, the U.S. Phillips curve was only vertical for five years from 1964 to 1969. Then, after a period of monetary turbulence in the 1970s, the Phillips curve became almost exactly horizontal from 1982 to 2013 — completely refuting the original conjecture.

Yet despite such empirical falsification, central bankers worldwide continued to behave as if Phillips curves were vertical. Even when they were forced to act far more radically after the crisis, they continued to justify and explain their policies as if they were still pursuing the orthodox objective of price stability — rather than trying to create employment and accelerate economic growth.

Which brings us back to the Yellen Fed. The orthodox monetary economics of the 1980s and 1990s clearly failed and highly-respected institutions such as the International Monetary Fund and the Bank of England have sometimes hinted at the need for a root and branch reconsideration of both the methods and the objectives of monetary policy. But only the Fed has the power and the intellectual credibility to overturn the totems of failed monetarism and start the search for a new and better understanding of macroeconomic policy.

Over to you, Professor Yellen.

PHOTOS: Federal Reserve Chair Janet Yellen testifies before a House Financial Services Committee hearing on “Monetary Policy and the State of the Economy.” at the Rayburn House Office Building in Washington, February 11, 2014. REUTERS/Mary F. Calvert

U.S. Federal Reserve Board Chair Janet Yellen (R) is photographed before testifying at the Senate Banking Housing and Urban Affairs Committee on Capitol Hill in Washington, February 27, 2014. REUTERS/Gary Cameron
16 comments

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Maybe the central banks failures of the past and continued failure concerning policy objectives should be seen for what they are – detrimental interference in market dynamics. They continue doing what they believe will affect the economy positively and talk about success being just around the corner yet it never really gets here. Their only answer has been more of the same hoping that the economy fully recovers and that they can then claim credit for that recovery (otherwise who needs them for that purpose). The unemployment objectives have only been political cover for continued QE and now that the objective is here new reasons need to be invented.

Posted by keebo | Report as abusive

“political independence of central banks from governments”

This is what got us into this mess and allowed unfettered greed to rape and destroy a generation….. globally.

It is a fine day for the marauders when globally – central banks are independent from governments and can move easily around the world, topple governments and buy governments as needed to keep independent control of all finance.

Money money money controls most everyone. This is the Holy Grail that some have dedicated their whole life to finding. You hold the grail and you rule the world.

Posted by Butch_from_PA | Report as abusive

Sure. Just keep printing more “Helicopter Money” so that they can inflate the up and coming Baby Boomers out of existence.

Posted by mickey58 | Report as abusive

blaming the weather was a good one, and the alacrity with which the press and the rest of the ruling class picked up that chant and recited it was amazing…

Posted by wilhelm | Report as abusive

I hope Yellen does the right thing and kickstart another round of QE! Call it QE 4 (400 billion every month) for just a year. That will solve the economic slowdown problem permanently.

Posted by Bugzy | Report as abusive

Poor dads with young kids should feel sorry for the future of their kids as we are entering “economic slavery era” technically. Prices have been pushed up in real terms but the FED says there is no inflation. Poor people will get poorer and become the new slaves soon.

Posted by Bugzy | Report as abusive

Just when stability rises to the forefront we get more de-stabilizing news, we now have a fed chief with a worldview based on keynesian theory. All we need now is the low info voter to wipe out the conservative congress an we can begin the wild ride to the Vensuelan economy complete with long lines and government suppression and confiscation. The era of the low info voter is about to begin, the result of an overweight liberally programmed electorate waiting for their free-stuff and willing to follow moral/political guidance from the hollywood drug culture.

Posted by gregio | Report as abusive

Does revived Keynesian economics at the Fed Reserve level really represent a solution to the world’s economic woes? I doubt it.

Keynesian economics has a place, but Kaletsky is offering a macro-economic solution to a micro-economic problem. I hope the Fed does not follow down this path.

The micro-economic problem relates to the profitability of firms in the face of cheap labour available from Asia. This is a challenge to the developed world that the political leaders of the west have not been prepared to even acknowledge.

There will come a time when the problem has become so acute that it will not be possible to continue to ignore it.

I hope that when that day comes it will not be too late to do something about it in a peaceful and generally productive way.

Posted by GrahamLovell | Report as abusive

We’ve just had a 5 year test of the most “growth promoting” fiscal and monetary policy in American history, and just coincidentally, the worst economic performance since the 1930′s.

So naturally, the author of this article thinks the way to guarantee future economic growth and well being is to do even more of the same.

Posted by NSJ4 | Report as abusive

Ms. Yellen can begin by establishing rules to regulate the pay of chief executives and board members of major U.S. banks and Fortune 500 companies. Free market rules have given the aforementioned executives the ability to obtain excessive salaries and bonuses far beyond their merit. This situation can only be regulated through federal regulation. I sincerely hope Ms. Yellen establishes market rules for U.S. private industry that ends the greed so prevalent in U.S. businesses.

Posted by joe10082 | Report as abusive

I have found that people wrongly judge Milton Friedman as the main representative of classical or neo-classical economics (those who supported free-market capitalism.) After familiarizing myself with the basics of neo-classical economists, it became obvious that Milton Friedman’s many theories, suggestions and proposals were wrong (from negative income tax to his math formulas to “third-party” liability.) In that light, this article looks amateurish and its author completely unable to understand the intellectual level of rational economists of the day. Since USA abandoned capitalism and sound money in 1933 for tyranny of majority and corporatism, sound economics is rarely taught in USA. For regular readers, I suggest a free PDF by Henry Hazlitt about his criticism of Keynesian economics which is available online.

Posted by SoundMoney123 | Report as abusive

let me share:

The truth is out: money is just an IOU, and the banks are rolling in it

http://www.theguardian.com/commentisfree  /2014/mar/18/truth-money-iou-bank-of-en gland-austerity

Posted by satori23 | Report as abusive

……..the Fed is contributing to an environment out of sync with reality.

the Fed is busy trying to support highly capitalized financial assets, while what we need is something that allows people to maintain a minimal standard of living.

Posted by Robertla | Report as abusive

It will take a long time for most people to realize that republican economic theories are just lies to give the rich more advantages. Targeting the money supply and inflation[reaganomics] are very subtle ways to help the super rich. The super rich are the debtholders in every corner of this planet. When you target the money supply debt instruments[bonds held by rich people]go up in value. When you have high unemployment bonds go up in value. Are you starting to see the light. These are the facts. Since we have been keeping records,1960,democrats have created more jobs,balanced the budget. and had higher GDP numbers by far so why would you ever vote for them?

Posted by lysergic | Report as abusive

The underlying reasons for FED policy is profit. Just like any profit making entity there has to be a mechanism that creates a surplus in their desired profit margin for the owners of the FED or they would be a failure of a business, Janet Yellen is simply the CEO of the FED. What does the FED want to gain in the sense of profit, what does the FED consider profit and how will they aquire that profit is what drives their policies. The rest of it is BS, this article is BS. The thing that Pushes people to understand why the FED does what it does are people that are trying to profit on the coattail of the FED. So does anyone on this forum have any ideas what the FED is gaining and who is the end benfactor of all those profit returns i.e. Interest Rates? Answer those questions and you’d be a lot more intellignet than the half wit that wrote this article.

Posted by MohanadHaroun | Report as abusive

Yellen, like the rest of the Fraud Squad – are part of the problem – not the cure

Posted by jackdanielsesq | Report as abusive