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Janet Yellen Is Far Too Confused To Plan A Stock-Market Rally

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It's said that the Federal Reserve frequently speaks to the public through reporters at major newspapers like the Wall Street Journal, and the Journal's Greg Ip is surely one of those reporters. In a column last week Ip, ever sympathetic to the Fed's way of thinking, described what he and Fed Chairman Janet Yellen see as the central bank's major problem:

"...moving too early [to raise interest rates] will derail the recovery, while moving too late will cause inflation to overshoot."

To all this Ip has a solution. Looking at what the Fed faces through the Phillips Curve glasses worn by central bankers and those who report on them, Ip is telling the Fed to "Allow the Economy to Overheat." As he explains it,

"Ordinarily, with unemployment now approaching levels associated with an economy at full strength, the case for raising rates would be open and shut: the Fed would not want unemployment to drop so far that the economy overheats and inflation takes off.

But these are not ordinary times. An overheating economy right now would be welcome. It would help nudge inflation back to more normal levels, restore some of the long-term growth potential lost since the financial crisis, and boost ordinary workers' wages..."

Where does one begin? While in the real world an economy is just a collection of individuals relentless in their pursuit of success and better pay, to the Fed and its watchers the economy is a blob that must have its movements centrally planned so that it doesn't get too hot or too cold.  In particular, the Fed doesn't want the blob succeeding too much. 

While the Fed is constantly looking for ways to stimulate the blob to "demand" things in its theoretical world, it doesn't want the blob to demand too much either The problem is that the real world is real. Not only are we already wired to demand things (that's why we work), but precisely because we produce in order to consume it's probably a bad idea for our central bank to seek debasement of the very dollars we earn. If they're worth less, that's generally not a good way to boost individual demand.

Just the same, the individual in the real economy (as opposed to the one imagined by the Fed) is reliant on work opportunities that make demanding the world's plenty possible in the first place. Put more clearly, the individual in the economy is reliant on investment without which there are not only no jobs, but also without which there is no investment in the productivity enhancements (computers, tractors, faster internet, etc.) that make it possible for workers to earn more to begin with. To state what is obvious in the real world, but apparently not obvious in the theoretical world inhabited by the Fed and elite reporters, when investors commit capital they are buying future dollar income streams. In that case, the last thing a central bank would ever do is pursue policies meant to devalue those income streams. Put more plainly, inflation is anti the very investment that authors the demand worshipped by central bankers.

A logical reply is that while inflation has historically been defined as currency devaluation, the Fed and its enablers in the media like Ip have defined it as something entirely different. There's some truth to the latter, yet it speaks to the shocking confusion that clouds the thinking of central bankers and reporters alike. The Fed thinks economic growth causes inflation. So does Ip. To believe Yellen or Ip, too much growth leads to labor and capacity shortages that cause inflationary price shocks. Or better yet, the logical impossibility that is an "overheating economy" is something the Fed wants to avoid.

Of course, missed by Ip, Yellen and others in the Fed's employ is that the U.S. economy is not an island. We know this well thanks to Fox's Lou Dobbs. Dobbs has developed quite the following for his rants against U.S. companies that have the nerve to utilize labor and capacity in countries not the U.S. Not only are labor and capacity stateside far from static, but as Dobbs constantly reminds us, American companies access the world's supply of workers and factories when they produce. Applied to the Fed and Ip's incorrect view of inflation, and if we accept what is incorrect for the purposes of discussion, the simple truth is that in an increasingly interconnected world U.S. companies are not limited by the supply of labor and capacity stateside.

But let's assume for a minute that they are. Let's us readers travel into the Fed's unreal world for a little bit. Assuming "America the Island," would too much growth cause the economy to "overheat" due to capacity shortages? Obviously not. Figure most readers no longer deal with a live human being while buying gasoline, movie or airline tickets, and it's increasingly the case that grocery shopping too is a solitary experience that ends with self-checkout. As we constantly see in an America that is decidedly not an island, markets regularly innovate such that we can do more with less labor. Thank goodness. Have any readers ever worked on a farm?

Importantly, the above truth further reveals the confusion that informs the thinking at the Fed, along with those who presume to report on the central bank. Yellen and Ip both comically fear too much growth as the driver of inflation thanks to growth allegedly causing labor and capacity shortages, but back in the real world something entirely different is at work.

Indeed, missed by those wedded to the Phillips Curve is that economic growth itself is all about a reduction in the need for labor. Think about it. Over the last 100 years some of the biggest authors of growth spurts (the car, the tractor, the computer, the internet) have been among the biggest erasers of once necessary forms of labor. To put it more simply, in the real world economic growth doesn't so much cause labor pressures as it relieves them. The Fed lives not just in an unreal world of America as an island with static amounts of labor and capacity, it also lives in an unreal world in which the nature of labor is unchanging.

Back to reality, growth spurts that result once again from cars, tractors, planes, trains, ATMs, computers, and internet relieve the economy of the need for human labor, but far from pushing us into breadlines, those advances that cause the supply of capital to surge in amount lead to all sorts of new forms of work. The Fed's models don't get this simply because in the eyes of the Fed and those reporting on it, nothing much changes.

In short, the Fed is confused. Stranded in a static world of its own making, unchallenged by reporters who are even more confused than central bankers are, the Fed doesn't see that economic growth doesn't overheat economies as much as it removes any labor pressures that might reveal themselves in the first place. In trying to centrally plan a not-too-hot economy, the Fed is at best robbing the economy of the very advances that would mitigate any presumed labor and capacity pressures that might emerge absent progress.

Looked at more broadly, can anyone seriously argue that a Fed this confused about the nature of inflation is somehow staffed with minds bright enough to centrally plan bull stock markets? The very notion is too silly for words. Sorry pundits, but a Fed this bewildered about simple economics is not tricking the deepest market in the world.

John Tamny is Political Economy editor at Forbes, editor of RealClearMarkets, and author of the new book Popular Economics: What the Rolling Stones, Downton Abbey and LeBron James Can Teach You about Economics.