Dr. Lacy Hunt: Fed Operating on a Flawed Model; "Wealth Effect" Only Widening Wealth Divide

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Yesterday we posted an excellent interview with internationally recognized economist Dr. Lacy Hunt of Hoisington Investment (click here for access). He is the author of two books and numerous articles and also served as a Senior Economist for the Federal Reserve Bank of Dallas.

Given his background, Dr. Lacy Hunt has now become a fierce critic of current Fed policy, claiming that the Fed is operating on a flawed model that is not only building future instability into the market, but also helping to further the wealth divide. Here we present a few comments from his recent interview:

The Federal Reserve bases part of its efforts to stimulate a “wealth effect” in the economy. What are your thoughts on this?

“[T]here’s really—never has been—any significant evidence that the wealth effect is very important. We have many cases where wealth goes up and down, but just like in the last 3 years when wealth has gone up it hasn’t translated into a faster rate of consumer spending—it’s been translated into a lower growth of consumer spending…you do find some very muted wealth effects on household incomes above $130,000, but even there the effects are miniscule. So, essentially, the Fed has expanded its balance sheet for naught and they may have produced unintended consequences that, ultimately, will be negative.”

You claim the Fed is working with a flawed model. Can you explain this?

“If someone makes regular statements about the economy and the model is operational, what you would expect to see is…individual forecasts above the trendline, some below the trendline—in other words, it would be scattered around it. What we see in the Federal Reserve’s case is that they constantly over-predict economic growth and they constantly over-predict the inflation rate, which means that they’re operating with a flawed model. They’ve been consistently too optimistic on growth and inflation. They believe their program should be effective, but it’s not effective, which suggests that they’re not going to have any more success in the future than they’ve had in the past…So the Fed has been working with a flawed model, quantitative easing has not helped the situation in the last several years, and there’s no basis for believing that the Fed will somehow get lucky going forward.”

How does Fed monetary policy negatively impact government fiscal policy?

“By expanding the balance sheet in these large sums it gives the appearance that the Fed is on the job doing something when, in fact, it is not; and it does take away the focus from fiscal policy. The problems that we face on the fiscal side are daunting and going to become increasingly more so as the years pass. The non-partisan Congressional Budget Office has put out projections that federal debt, which is now in excess of 100% of GDP, will be 200% in 20 or so years. It’s going to march steadily higher. We’ve made substantial promises to Social Security and Medicare. Frankly, we’re going to have to try to borrow the money in order to meet them; whether we can borrow the money on a long-term basis remains an open question. So, to deal with the fiscal situation there are no simple levers. There’s no magic elixir. It’s going to require substantial shared sacrifice, and it’s going to require very decisive political leadership. So, when the Fed is active and appearing to be doing something that’s helpful, it takes the pressure off of the fiscal sector to deal with the hard problems that are going to become increasingly more difficult as the time passes.”

From your point-of-view, what are the main consequences of current Fed policy for the average American and society in general?

“The bottom line is that Federal Reserve policies encourage speculation and excessive risk-taking and with very little benefit in generating economic growth. And so the net result...is it may just actually worsen the income and wealth divide. Those that benefit from the short-term gain in the speculative assets that rise in this type of environment—they’re better off—but the broad majority of our households are not helped and so the income and wealth divide increases as a result of Federal Reserve policy.”

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