The world of Bubble Finance economies created by the Fed and other central banks is fundamentally different than that prevailing under the “Lite Touch” monetary policies which preceded the Greenspan era.

Those essentially reactive and minimally invasive central bank intrusions into the money and capital markets prevailed from the time of the Fed’s 1951 liberation from the US Treasury by the great William McChesney Martin through September 1985. That’s when the US Treasury/White House once again seized control of the Fed’s printing presses and ordered Volcker to trash the dollar via the Plaza Accord. In due course, the White House trashed him, too.

The problem today is that the PhDs running the Fed have an economic model which is a relic of the Lite Touch era. It is not only utterly irrelevant in today’s casino driven system, but is actually tantamount to a blindfold. It causes them to look at a dashboard full of lagging indicators, while ignoring the explosive leading indicators starring them in the face.

The clueless inhabitants of the Eccles Building do not recognize that they have created a world in which Wall Street supersedes main street; and in which the monetary inflation that eventually brings the business cycle to a halt is soaring financial asset prices, not wage rates and new car prices.

During the Light Touch era recessions were triggered by sharp monetary tightening that caused interest rates to surge. This soon garroted business and household borrowing because credit became too expensive. And this interruption in the credit expansion cycle, in turn, caused spending on business fixed assets and household durables to tumble (e.g. auto and appliances), setting in motion a cascade of recessionary adjustments.

But always and everywhere the pre-recession inflection point was marked by a so-called wage and price spiral resulting from an overheated main street economy. Yellen’s Keynesian professors in the 1960s called this “excess demand”, and they should have known.

Professor James Tobin in particular, Yellen’s PhD advisor, had been the architect of a virulent outbreak of this condition during his tenure in the Kennedy-Johnson White House. He had been a pushy advocate of massive fiscal deficits under the guise of full employment accounting, and then had encouraged Johnson to unmercifully browbeat William McChesney Martin until he relented and monetized LBJ’s massive flow of “guns and butter” red ink.

That is to say, free market economies really don’t “overheat” on their own motion. The old fashioned kind of wage and price spirals happened because even Lite Touch central banks did not allow financial markets to fully and continuously clear.

Instead, they tended to sit on the front end of the yield curve too heavily and for too long. This tendency prevented the market from rationing excess demands for loanable funds through a flexible free market interest rate. A rising price for credit, of course, would curtail borrowing and induce additional savings and less spending, thereby preventing the general economy from getting out of balance.

In the era of Light Touch monetary policy, therefore, the Fed caused every recession, including when it accommodated artificial economic booms generated by war spending during Korea and Vietnam. That’s why it was perennially criticized by sound money advocates for being “behind the curve”.

Nevertheless, in attempting to belatedly catch-up the Fed invariably was forced to throw on the monetary brakes, as is was usually described. In due course, the rise of idle labor and industrial capacity would cause product price inflation to cool until it reached a low enough rate relative to the recent past to satisfy the FOMC to supply new reserves to the banking system, and thereby restart the process of credit expansion.

(Click on image to enlarge)

>>> Read: The Bubble Finance Cycle: What Our Keynesian School Marm Doesn’t Get, Part 2