Central bankers are happily behind the curve

Those urging the Federal Reserve and other central banks to raise their cash rates in line with economic recovery have missed the point: these days the game is about warding off deflation, not inflation.

The chairman of the US Federal Reserve Board between 1951 and 1970, William McChesney Martin, famously described the job of central banking in a speech in 1955: “The Federal Reserve … is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

Paul Volcker, appointed in August 1979, confirmed that idea by immediately raising the Fed funds rate to 12 per cent and then to 20 per cent in 1981.

The result was a devastating global recession. Unemployment in the United States hit 10.8 per cent in November 1982, and in Australia it peaked at 11 per cent.

What's more, Volcker kept taking away the punchbowl through the first half of the ‘80s -- every time the economy looked like it was warming up, he raised the Fed funds rate again, to ensure that inflation was crushed permanently.

That's what central bankers used to do. Their self-appointed task has now completely changed -- in fact it has reversed, and a lot of people have not fully cottoned on to this yet.

The Fed -- and the European Central Bank, Bank of Japan and the Bank of England, and bobbing behind them in a slightly leaky rowboat, the Reserve Bank of Australia -- are trying to crush deflation, not inflation. The difference, and the implications, could not be greater.

With the US economy clearly doing quite nicely now, the Fed is commonly described as being “behind the curve” -- that is, not reacting quickly enough to the recovery, so that at some point it will have to catch up, destructively.

That fundamentally misunderstands how the Fed, and central bankers generally, now regard their job. They are deliberately and happily behind the curve, just as Paul Volcker was deliberately ahead of it in the 1980s.

Volcker decided to turn the 1980 peak in inflation into a permanent turning point for the US economy, so he raised interest rates higher than anyone thought possible and kept them there even as inflation collapsed.

As the 80s wore on, and Volcker was succeeded by the Ayn Rand devotee Alan Greenspan, the bond market took over. Economist Ed Yardeni coined the term “bond vigilantes”, as bond investors decisively punished any fiscal or monetary laxness with rapid increases in yields. President Clinton became the target of bond vigilantes in 1993-94 and was forced to turn the federal deficit into a surplus. And in Europe between 2009 and 2011 bond vigilantes forced many countries into politically difficult austerity programs.

Now this world is upside down. Bond yields are falling and the bond vigilantes have been tamed: yield-hungry investors are meekly buying German bonds at 1.1 per cent yield and Spanish bonds -- Spanish! -- at 2.5 per cent, the same as the US 10-year bond yield.

Anatole Kaletsky of GaveKal Research wrote recently that “as long as … investors view US or British bonds offering 2.5 per cent yields as a ‘deep value' investment, the Fed and Bank of England can laugh at ‘market pressure' to bring forward rate hikes”.

In fact, freed from any pressure from the now-retired bond vigilantes, the Fed under Ben Bernanke and now Janet Yellen has taken a leaf from Paul Volcker's book. Just as Volcker decided in 1980 that the US would never again experience 10 per cent inflation, Bernanke and Yellen have decided to make sure that the deflation of 2009 remains nothing but a memory.

That's why they have reacted to the clear signs that the US economy is recovering by only repeating that the Fed funds rate will remain effectively at zero for “an extended period”.

Not only that, the Fed wants to see real wages rise, not just unemployment fall. As Yellen said last month on the subject of rising real wages: “Within limits, it's not a threat to inflation because consistent with the level of inflation we have for our 2 per cent inflation objective, we could see wages growing at a more rapid rate and -- a somewhat more rapid rate…”

Paul McCullough of PIMCO wrote last week: “The war on inflation was won long ago, and the time has come for a peace dividend paid to labor. Yes, to labor, not capital.”

“Behind the curve!” shout the inflation warriors of the 1980s and 1990s. “You bet,” replies Janet Yellen; or rather, to quote her properly: “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”