The new Obama Fed is going to be very dovish when it comes to fighting future inflation and defending the value of the dollar.
The president has nominated Janet Yellen to be vice chair of the Federal Reserve. Ms. Yellen is a distinguished economist who unfortunately subscribes to the Phillips-curve model that trades off unemployment and inflation. In other words, rather than excess money creation as the cause of rising prices, she focuses on the unemployment rate, the volume of new jobs being created, and the growth of the overall economy. For Ms. Yellen, inflation is caused by too many people working and too much economic prosperity.
And since we have the opposite problem today -- high unemployment and too few people working -- she will be the last Fed governor to turn out the lights on the central bank’s zero interest rate.
There is no evidence in Ms. Yellen’s public opinions or speeches that she might use a market-price rule -- targeting commodities, gold, bond rates, or the dollar -- as a forward-looking inflation (or deflation) signal. So the absence of a commodity- or dollar-price rule will continue at the Fed. Ben Bernanke doesn’t use a market-price rule, and Obama’s additional Fed appointees -- whoever they are -- will undoubtedly come from the same Phillips-curve camp.
Supply-siders like myself who believe that only market prices can provide accurate signals of the supply and demand for money are going to be very disappointed. If the Fed supplies more cash than markets want, the inflation rate can go up whether unemployment is high or low. We learned this painfully in the 1970s, when high unemployment was accompanied by high inflation.
Even more troubling, fiscal policies coming out of Washington will reduce the investment demand for money. This is because tax rates on those individuals, families, and entrepreneurs who are most likely to save and invest are going up. Rather than extending the Bush marginal-tax-rate cuts on capital gains and other forms of investment, Washington will let that tax relief expire at the end of this year.
On top of this, Obamacare proposes to apply the 2.9 percent Medicare payroll tax on ordinary labor income to capital gains, dividends, interest, and profits from passive investments in partnerships and S-corporation small businesses.