An Open Letter to Janet Yellen

Dear Chair Yellen,

As a kid from Queens I am always willing to give the benefit of the doubt to a kid from Brooklyn. Nevertheless in your great fear of avoiding an error of commission I fear you are on track to a make an error of omission. I realize that you rightfully fear that Fed might raise rates prematurely thereby stalling or even reversing the economy’s painful progress since the Great Recession lows of 2009. Although it happened 77 years ago, the Fed is still haunted by its policy tightening in 1937 that was one of the proximate causes of the severe 1937-38 downturn. Never mind that my reading of the history of that period would assess much of the blame on a sudden contraction of fiscal policy.

More recently we all witnessed the severe bond market effects a year ago of your predecessor’s comments about the need to start tapering the Fed’s bond buying program. Although not the only cause, it certainly knocked the wind out of what was looking like a very strong housing upturn. Just as in medicine, the principle of “do no harm” certainly works for central bankers.

However, when you called the recent uptick in the consumer price index “noisy”, you ignored some really important evidence that the economy shifted its bias away from deflation and towards inflation. You know the data far better than I, but to state a few facts on a year-over-year basis headline inflation as measured by the CPI is now running at 2.1% and the core rate is 2.0%. And for two important categories, tenant paid rent and medical care services the year-over-year rate of increase is 3%, hardly benign. Moreover the rent component is understated because the over-weighting of rent controlled jurisdictions in the data tends to suppress measured inflation in a rising rent environment.  Indeed, over the last three months headline inflation is now running at a 3.3% rate and core inflation 2.8%. To me there is more signal than noise in the data.

Yes, I know the Fed uses the deflators for personal consumption expenditures to measure inflation and by those measures year-over-year inflation as of April is running at around 1.5% (1.6% headline and 1.4% core), well below your 2% target. But I caution you, the public likely measures inflation by the widely publicized CPI and if that appears to running well above 2%, the well anchored inflation expectations that the Fed loves to brag about might soon give way.

To be sure measured wage inflation remains modest at 2% and if we looked at that alone, there would not be much to worry about on the inflation front, but a lot to worry about on the labor market front. However there is hard statistical evidence that the labor market is improving with the unemployment rate on the road to below 6% by yearend and anecdotal evidence that wage rates are picking up. A good thing, but when you combine that with the other inflation data cited above, it will be harder for you to be so cavalier about the uptick in inflation .It would be better to start laying the ground work now, rather than waiting until it is too late. History suggests that a Fed behind the inflation curve wreaks far more havoc on the financial markets than one modestly ahead of it.

On that score I would note that after your press conference last week both the TIPS market and the gold market rallied strongly. A few days don’t make a trend, but these auguries of inflation might just be sending you a message.

Let me add that you may have something more to worry about than signs of “irrational exuberance” in the credit markets and recent surge in corporate mergers and acquisitions. There are signs in the real economy of what the Austrians, and I do not call myself an Austrian economist, of malinvestment. For example there is real evidence that the demand for electric power generating facilities, office building, shopping centers and hotels are about to be technologically disrupted. Yet investment, in those areas, especially in existing assets, continues unabated because the capital market remains wide open to them. Trust me, an unwind here will not be pretty.

Finally, let me close by rephrasing what I noted earlier. Sometimes an error of omission can be just as dangerous as an error of commission. Meantime enjoy your trip to beautiful Jackson Hole later this summer.

Yours truly,

David Shulman