Treasury Secretary Yellen's Gaffe

You kind of knew this was going to happen eventually. You’re just probably surprised it happened so fast and so publicly.

After serving as Federal Reserve chair for four years, until February 2018, and now Treasury Secretary since January, Janet Yellen could probably be forgiven for forgetting what position she holds. After all, in addition to being located in Washington, both the Fed and the Treasury pretty much work hand in hand, with the former directing monetary policy and the latter handling fiscal policy. Under the pretense, they’re both independent of each other.

But last week, Yellen let the cat out of the bag and ignited a one-day mini taper tantrum in stock prices, which is a little hard to understand, given that she only said what everyone else was already thinking. (But as we know, a gaffe is when a politician or government official accidentally tells the truth).

“It may be that interest rates will have to rise somewhat to make sure that our economy doesn’t overheat, even though the additional spending [proposed and already enacted by the Biden Administration] is relatively small relative to the size of the economy,” she said in a prerecorded interview at the Atlantic’s Future Economy Summit.

Later on, of course, she walked that back a little, telling the Wall Street Journal, “I don’t think there’s going to be an inflationary problem, but if there is, the Fed can be counted on to address it,” she said.

It was certainly much ado about nothing, but it raises an important question, namely: Other than raising interest rates, either directly or indirectly, what exactly can the Fed do to fend off higher inflation?

About a week before Yellen spoke, her successor as Fed chair, Jerome Powell, following the Fed’s April monetary policy meeting, declared, “If we see inflation moving materially above 2% in a persistent way that risks inflation expectations drifting up, then we will use our tools to guide inflation and expectations back down to 2%. No one should doubt that we will do that,” he said.

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The markets seem to have accepted that, but this is the same Fed that has been trying for the past dozen years – four of them under Yellen – to raise inflation to a sustainable 2% rate without success. Only now, with a post-pandemic economic boom about to explode while Yellen’s boss, President Biden, wants to spend gazillions on everything, has inflation started to catch fire, all with very little assistance from the Fed. Yet we’re supposed to believe that the Fed can magically use its “tools” to “guide” inflation, all without raising interest rates.

There are only a few ways the Fed could try to “guide” inflation in this environment, but all of them involve raising interest rates, either directly or indirectly. The most obvious way is for the Fed to raise the short-term federal funds rate, the only rate it directly controls. Since the Fed seems to see that as a last resort, it could also start reducing its massive asset purchase program, but that would trigger even more inflation and still higher interest rates since the Fed is by far the biggest buyer of U.S. Treasury debt just as the federal government is spending the equivalent of what it spent to finance World War II, albeit without the war. But the Fed has already said it has no plans to do that either, not at least for the next 18 months or so. It could also execute some behind-the-scenes monetary operations, such as making it more expensive for banks to make loans, but that would also have the effect of raising interest rates.

So it would appear that the Fed has backed itself into a corner—promising to keep inflation under control all while keeping interest rates near zero. Good luck with that.

While it’s still too early to know if current inflationary pressures will be sustainable, make no mistake that they’re starting to build. Manufacturers are warning that they’ll have to start passing along the cost of soaring commodity prices. Corn prices jumped 31% last month while wheat climbed 20%; that will eventually hit supermarkets. Lumber prices are up 130% since the pandemic started, while crude oil has risen 31% so far this year, pushing unleaded gasoline up by nearly 50%.

These aren’t bad things, of course. They’re the result of pent-up demand after a year in lockdown, combined with massive fiscal stimulus. The problem is that the Fed has tried to convince us that we can have all of these good things without the mild pain of higher interest rates, which is bad for stock and bond prices. Modern Monetary Theory, which preaches that inflation is the flag that shows governments are spending too much, is about to be tested.

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George Yacik Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from for their opinion.

One thought on “Treasury Secretary Yellen's Gaffe

  1. “Backed itself into a corner”? How many corners has the Fed backed into over the past decade? This charade is becoming a four dimensional Rubik cube. While everyone talks inflation, history shows the end result will be debt write-downs/write-offs, IOW massive *deflation*.

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