WHAT GREG CONLON LEARNED ON DR. JOHN B. TAYLOR DAY—January 20, 2013

WHAT GREG CONLON LEARNED ON DR. JOHN B. TAYLOR DAY—January 20, 2013

Famous scholar Dr. John Taylor is a professor of economics at Stanford University and Senior Fellow at the Hoover Institution. He was also a former Treasury undersecretary for international affairs and a member of the U. S. President’s Economic Counsel for several Presidents starting with President Ford. January 20th was his day as far as I am concerned, he published an Opinion piece in the morning Wall Street Journal entitled, “Fed Policy is a Drag on the (U S) Economy,” then that evening he was the guest speaker at a political event of the Northern California Republican Lincoln Club in San Francisco which I attended.

His comments were complex and difficult for the non-economist to fully understand but let me share with you what I learned from reading his article, listening to his comments at the Lincoln Club event and my personal questions related to the same area regarding the Federal Reserve’s latest actions and future indicated actions.

First, the Fed has increased its purchases of U. S. Treasury bonds and mortgage-backed securities. Its stated intent is they are going to buy more in the future, and these purchases and low interest rate the Fed charges the banks to use its funds, nearly zero interest rate, is going to continue for several years. It seems obvious to me that if the U S Treasury continues to issue its securities to finance the Federal government’s deficit and the Fed continues to buy the Treasury’s securities there will have to be an increase in inflation or great pressure on inflation to increase. To prevent this from occurring the Fed would normally sell the U. S. Treasury securities into the market. But if this is done too fast or if sales are too large all at once, it will drive the price of the US securities down and interest rates up. This would cause havoc in the economy and could cause a recession.

Second, Dr. Taylor espouses that the Fed’s policy of saying that it intends to keep short-term rates low into the future has the effect of putting a so-called cap on long-term interest rates because smart portfolio managers can arbitrage the short and long term rates with the effect of keeping the long-term rates down into the future. These low short and long-term rates distort the normal relationship between borrowers and lenders. While borrowers would like the lower rates, the lenders would have less incentive to extend credit at the low rates. Dr. Taylor further states that it is like a price ceiling in rental housing where there is little incentive for landlords to build more houses with artificially low rental rates that will not recover the higher current construction cost of newer units. In the money market, artificially lower interest rates mean lenders would supply less credit to borrowers. This decline in credit availability reduces aggregate demand, which tends to increase unemployment with less construction and less jobs.

With the Fed announcing the continuation of the low interest rate policy, Dr. Taylor believes it will make matters worse. If the economy should go into the up side we can hope that it will cause the Fed to buy less, not more, U S Treasury securities and perhaps stop buying all together. He states this will bolster growth and help put the economy on a sustained recovery path. On this same day, it was announced that the GDP growth for the fourth quarter was low and less than 2% for the year 2012. Again according to Dr. Taylor positive growth coming out of a recession would be better caused by the Fed buying less, or no, U S Treasuries to put the economy on a sustained recovery path.

GREG CONLON’S PERSONAL VIEWS ON THE MATTERS–

All along my concern as an interested observer is that we will see runaway inflation if the Fed finances most of the annual $1.0 trillion deficit by buying U S Treasury securities off the market and China buys less. I believe the two events that would trigger a major change in Fed policy and reduce the risk of runaway inflation would be if one or all the financial rating agencies down-grade the U S Treasury securities again or if China greatly reduces its purchases of U S treasury securities or starts selling US securities it owns in the open market. This will drive interest rates up and cause a more severe second recession. I certainly hope that I am wrong and that neither event occurs, but the higher interest rate risk is there if either event does occur.