Janet Yellen really can't do much about the American economy

Jun 19, 2015

- By Vivek Kaul

Vivek Kaul
In the past columns I have written for The Daily Reckoning I have maintained that the chances of the Federal Reserve of the United States starting to raise the federal funds rate in the time to come, remain low.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their loans.

In a column dated March 20, 2015, I had said that we have to be prepared for "for Janet Yellen offering more excuses for not raising the federal funds rate in the days to come." Yellen, is the current chairperson of the Federal Reserve of the United States, the American central bank.

The Federal Open Market Committee, which decides on the federal funds rate, met on June 16-17, 2015. In this meeting the FOMC decided to keep the federal funds rate in the range of 0-0.25%. After the meeting, Yellen spoke to the press. In this interaction Yellen talked about the fact that many American couples are "delaying marriage [because they] can't get mortgages as easily".

The home-ownership rate in the United States fell to 63.8% during the first three months of 2015. It had stood at 65% in 2014 and 69.2% in 2005, at the peak of the housing bubble in the United States.

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Yellen, by keeping the federal funds rate at extremely low levels hopes that banks will give out home loans at low rates of interest and this will lead to more people buying homes. But as I keep repeating in my columns-monetary policy is overrated.

James Montier of GMO in a recent note titled The Idolatry of Interest Rates writes about "the modern-day belief in the world's greatest con: that monetary policy matters." "There is precious little evidence that monetary policy matters for the major components of demand (investment and consumption look pretty immune to the shifts in interest rates over time)," writes Montier.

Further, as far as the home-ownership rate in the United States is concerned, it might be going back to the natural level that prevailed before the real estate bubble started in the early 2000s.

As Alan Blinder, an economist and a former vice-chairman of the Federal Reserve, writes in After the Music Stopped : "Home-ownership simply reached an unnatural high of 69 percent of all American housing units in 2004 and 2005-up from 64 percent just a decade earlier. Just not as everyone likes vanilla ice-cream, not every American wants(or should) own a home. For some people renting is a better option." Hence, the rate of home-ownership in the United States is probably coming back to the level at which it should be.

The official rate of unemployment in the United States for May 2015 stood at 5.5%. This seems like a very respectable number given the 10% levels it had reached during the heydays of the financial crisis.

But that is clearly not the case. The labor force participation ratio, which is a measure of the proportion of the working age population in the labor force, was at 62.9% in May 2015. Such low levels of labor force participation were last seen in the late 1970s. During the height of the real estate boom in the United States in the mid 2000s, the number had almost touched 67%.

What this also tells us very clearly is that the rate of unemployment in the United States has been falling primarily because of the fact that the unemployed have been giving up looking for a job and thus dropping out of the workforce. This ensures that they don't get included in the official statistics and the official unemployment number looks good. Also, the low-level jobs that are being created cannot lead to a sustainable economic recovery.

Janet Yellen obviously understands this and is not really in a position to raise the federal funds rate, despite repeating the same after almost every Fed meet.

As she said after the latest meet: "No decision has been made about when the right timing is for an increase," Yellen told the media. "Certainly an increase this year is possible, we could certainly see data that would justify that," she added. She also made it clear that she was not going to put a date on when interest rates would go up, saying it could be "September, or December or March".

Central bank governors like to believe that low interest rates make a difference. They get companies to invest more. They get consumers to spend more. And this creates jobs. But the real world is nowhere as simple as that.

As Raghuram Rajan writes in Fault Lines: How Hidden Fractures Still Threaten the World Economy : "Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance... Politicians love to have banks expand housing credit... It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe-as safe as houses-at least for a while." And this is precisely what Yellen and the Fed are trying to do all over again.

What caused the problem in the first place is now being sold as a cure.

The trouble with the American economy and large parts of the Western world is essentially what economists like to call "structural" in nature. As Rajan and Luigi Zingales write in a new afterword to their classic book Saving Capitalism from the Capitalists : "For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things."

Interestingly, between 1900 and 1980, 70-80 percent of the global production of goods happened in the United States and Europe. By 2010, this share had declined to around 50 percent, around the same level it was at in 1860. (Source: Thomas Piketty, Capital in the Twenty-First Century).

And this is the fundamental problem about which the Federal Reserve and Janet Yellen can really do nothing about.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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