You might think that today's Daily Reckoning is going to be a boring rant against central banking...again. But we urge you to read it, because the thinking at the US Federal Reserve is getting increasingly dangerous. It looks like they're positioning monetary policy to more forcefully target the US unemployment rate. These guys are starting to lose it...

Overnight Bernanke released a few Fed hounds to talk more on the correct conduct of monetary policy.

First there was Governor Jeremy Stein. He gave a pretty decent speech earlier this year on the inherent financial risks brought about by prolonged low interest rates. But his latest effort only confused us. We think someone made a bet with him that he couldn't use the word 'hydraulic' in a sentence. Looks like Stein won:

'One view would be that the configuration of market rates in early May was largely a directhydraulic outcome of our policies.'

Ironically, Stein then goes on to say that the Fed's communication about its tapering timetable could indeed be better. He proposes linking the pace of tapering to the unemployment rate, so the market knows exactly what the Fed is looking at.

Stein is trying to come up with a mechanism for tightening that is non-discretionary. That is, take the tightening timeline out of the hands of Bernanke and into the hands of cold hard data. That's a step in the right direction (we don't need discretion) but what measure of unemployment, or any data point for that matter, do you use?

If people stop looking for work and give up on life, the unemployment rate drops and the Fed will tighten. But if the Fed uses a broader measure, they'll probably increase the pace of QE (got to do more to help the job market!) which will further distort the US economy and make things even worse.

When you're in a hole, the first thing to do is to stop digging. But these guys love a good shovel.

And then there's President of the Minneapolis Fed, Narayana Kocherlakota. His speech heavily targeted the labour market and what monetary policy can do to fix it. So two speeches on the same day talking about the same targets.The Fed is clearly trying to gauge the reaction of the market by aligning the question of tapering with the jobs data. We're guessing they're hoping that good news on jobs will outweigh the concurrent bad news on tapering and that they can indeed get themselves out of the hole they've been digging for years.

Kocherlakota's speech caught our attention because he titled it 'A Time of Testing', the same title that Paul Volcker gave to a speech in October 1979. He then went on to make parallels (seriously) between 1979 and 2013, only that now the Fed is fighting an employment problem, not an inflation problem. Seriously.

That's not to downplay the deep structural problems in the US jobs market. As you can see below, it's a national tragedy. The amount of people on food stamps is at a record high, and the numbers for 2013 (a year of 'recovery') are so far slightly higher again.

click to enlarge

Source: Matt Trvisonno's Blog

The unemployment rate in the US peaked in October 2009 at 10% and is now 7.3%. But these numbers ignore the people who have dropped out of the workforce. In 2007 the 'participation' rate was around 63%. Now, it's 58%.

In other words, despite the Fed dropping interest rates to zero and expanding the size of its balance sheet to nearly $3.8 trillion, the employment market has hardly responded (when you take participation into account).

Most thinking human beings would draw certain conclusions from this. But not central bankers. Kocherlakota's conclusion? Do more. Seriously. He reckons inflation is too low and that an increase in inflation usually translates into an increase in employment. So create inflation and your employment problem is gone. Or, in the Koch's textbook language (our emphasis):

'At a basic level, monetary stimulus increases the demand for goods among households and firms. This higher demand for goods tends to push upward on both prices and employment.'

Meanwhile, asset price inflation and speculation is rampant and the resulting 'rising tide' is only lifting the yachts, to borrow a great phrase from Ed Miliband.

To compare the situation today with 1979 is drawing a very long bow indeed. Firstly, the whole point of central banking is to maintain some semblance of price stability. Employment has always been a secondary concern and it's a part of a central banker's mandate for political reasons rather than the belief they can actually improve employment.

In 1979, inflation in the US was out of control. The Iranian revolution earlier in the year caused a massive spike in the oil price, which peaked at US$38 per barrel in December 1979 (around US$115 in today's dollars). There were gas shortages across the country, hundreds of hostages held in Iran, and President Carter was under siege. The US dollar, the world's reserve currency, was under huge pressure and the financial system was close to coming apart.

Volcker flew to Belgrade for an IMF meeting in late September. After speaking with the Europeans (who were the main buyers of US debt and therefore the US dollar) he flew home early and moved fast to start tightening policy. He convened a special Fed board meeting on a Saturday. He was on a mission to save the dollar.

He came up with a plan to target the money supply, rather than rely on discretionary judgement to alter the Fed Funds rate, which is the official interest rate and what the Fed usually does to determine monetary policy. This targeted, non-discretionary approach saw short term market interest rates jump from 9.5% in August 1979 to 16% by 1981.

It was extreme, but it was necessary to stabilise the system and, as Volcker foresaw, set the stage for a new period of prosperity.

Now you've got the Fed invoking Volcker to do the opposite - take monetary policy to the extreme to get desired labour market outcomes. Volcker would be horrified.

Regards,

Greg Canavan+

for The Daily Reckoning Australia