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Failing The Test of Common Sense?

Today’s Op-Ed section of the Wall Street Journal contained a piece by Christian Broda and Stanley Druckenmiller addressing the Federal Reserve’s stance on rates, saying it fails the test of history and common sense.  We would agree.  Below are excerpts from their opinion piece highlighting points similar to what we discussed in our letter last October, Impolitic Fed 2014 October Quarterly Point of View

The Fed’s Faulty 1937 Excuse

By Christian Broda and Stanley Druckenmiller

Policy makers and financial pundits insist that the risk of the Federal Reserve raising rates too early exceeds that of moving too late. The Fed appears to agree. In recent years, the Fed has repeatedly moved its goal posts, seemingly to avoid raising the federal-funds rate from near zero.

But is the prevailing consensus correct if emergency economic conditions are long past?

Comparisons with 1937 or with Japan in the 1990s are commonly used as examples of mistakes to avoid. Both occasions were preceded by a severe financial crisis, and years later monetary policy was prematurely tightened.

The differences between the current policy conjuncture and these historical analogues are striking, however. Eight years after the 1929 crash, consumer prices in the U.S. had fallen by a cumulative 18% and unemployment remained above 14%. And in Japan today prices are still down relative to their pre-banking crisis levels.

In contrast, since 2007, prices in the U.S. rose by an accumulated 16%, and the Fed’s favorite annual inflation measure has never been below 1%. Current unemployment is at 5.5%, the same rate prevailing in the boom years of 1996 and 2004. The U.S. is currently far from being mired in deflation and low growth as was the case in the late 1930s or in Japan in the 1990s. Therefore the initial conditions for considering the conduct of future monetary policy are radically different…

…Near-zero rates during and in the years after 2008 no doubt helped end the so-called Great Recession. But the U.S. economy is no longer under emergency conditions or facing the perils of 1937. Why then does it require emergency monetary policy? While inflation targeting gave no warning of what was to come in 2008, why is inflation moving from 1.5% to 2% a necessary condition for raising rates from the current emergency levels? Even models that the Fed used to justify quantitative easing (QE) in recent years are today pointing to rates well above 1%. Why now use new, untested theories to justify zero?

….QE has ushered in a new sense of power by central banks. Yet monetary policy has limitations. It is mostly well-suited to filling in temporary shortfalls in demand. Except for exceptional conditions, it borrows growth from the future.

The Fed seems all-too-convinced that this is a trade-off worth making. With unemployment at 10%, history was likely on their side. At a 5.5% unemployment rate, it fails the test of history and common sense. May the risk-reward of too early versus too late prevailing in policy circles be backward?

Mr. Broda is a managing director at Duquesne Capital Management. Mr. Druckenmiller was the founder of Duquesne Capital and is the CEO of the Duquesne Family Office.


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