The new Obama Fed is going to be very dovish when it comes to fighting future inflation and defending the value of the dollar.
The president has nominated Janet Yellen to be vice chair of the Federal Reserve. Ms. Yellen is a distinguished economist who unfortunately subscribes to the Phillips-curve model that trades off unemployment and inflation. In other words, rather than excess money creation as the cause of rising prices, she focuses on the unemployment rate, the volume of new jobs being created, and the growth of the overall economy. For Ms. Yellen, inflation is caused by too many people working and too much economic prosperity.
And since we have the opposite problem today -- high unemployment and too few people working -- she will be the last Fed governor to turn out the lights on the central bank’s zero interest rate.
There is no evidence in Ms. Yellen’s public opinions or speeches that she might use a market-price rule -- targeting commodities, gold, bond rates, or the dollar -- as a forward-looking inflation (or deflation) signal. So the absence of a commodity- or dollar-price rule will continue at the Fed. Ben Bernanke doesn’t use a market-price rule, and Obama’s additional Fed appointees -- whoever they are -- will undoubtedly come from the same Phillips-curve camp.
Supply-siders like myself who believe that only market prices can provide accurate signals of the supply and demand for money are going to be very disappointed. If the Fed supplies more cash than markets want, the inflation rate can go up whether unemployment is high or low. We learned this painfully in the 1970s, when high unemployment was accompanied by high inflation.
Even more troubling, fiscal policies coming out of Washington will reduce the investment demand for money. This is because tax rates on those individuals, families, and entrepreneurs who are most likely to save and invest are going up. Rather than extending the Bush marginal-tax-rate cuts on capital gains and other forms of investment, Washington will let that tax relief expire at the end of this year.
On top of this, Obamacare proposes to apply the 2.9 percent Medicare payroll tax on ordinary labor income to capital gains, dividends, interest, and profits from passive investments in partnerships and S-corporation small businesses.
Saving and investment are already double-taxed several times over. This includes the inheritance tax, which is slated to rise substantially next year. But taxing successful investors and earners is the exact wrong policy.
Alan D. Viard of the American Enterprise Institute writes that 2007 tax returns from households with incomes greater than $200,000 reported 47 percent of all interest income, 60 percent of all dividends, and a “staggering” 84 percent of all net capital gains. These folks are the economic activists, the ones most likely to reemploy their investment gains into new job-creating businesses. But these new tax penalties will blunt their investment activities, thereby reducing the demand for money. Of course, the whole economy will suffer as a result.
Even with the same volume of money in circulation, new tax penalties from Washington will lower money demand for investment purposes, making each new dollar printed by the Fed that much more inflationary. So the great risk is that rising tax rates will make the Fed’s bloated balance sheet even more inflation prone over the next few years. As many have noted, inflation itself is the cruelest tax of all.
The original supply-side model crafted by Robert Mundell and Art Laffer argued that low tax rates and a tight-money-linked sound dollar was the best path to maximizing economic growth. This model prevailed through the highly prosperous 1980s and 1990s. Launched by Ronald Reagan, it basically continued, with a few bumps here and there, through Bush 41 and Bill Clinton. But the dollar side of the model was badly broken during the 2000s, and at the moment, it looks like it may stay broken.
This is a crucial juncture. The Fed is going to encounter excruciatingly difficult problems as it deals with the magnitude and timing of its decisions to start withdrawing excess cash and raising the fed funds target rate. Markets should be the guideposts for these decisions, not the unemployment rate.
Janet Yellen, who served as a top economic advisor to President Clinton and was a Clinton appointee to the Federal Reserve Board, has for the past six years been the president of the San Francisco Fed. She is a very able economist. But if you work from the wrong money model, you are likely to get the wrong money results.
