Fed Flashback 2008
One of my personal favorite posts, and I have been blogging since March of 2002, is my April 3, 2008 post Fed Uncertainty Principle
This is the same post, but stripped of much of the discussion of the events at the time.
Does the Fed Follows the Market?
Most think the Fed follows market expectations.
However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?
This is a very interesting theoretical question. While it’s true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.
The Observer Affects The Observed
The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.
To measure the position and velocity of any particle, you would first shine a light on it, then detect the reflection. On a macroscopic scale, the effect of photons on an object is insignificant. Unfortunately, on subatomic scales, the photons that hit the subatomic particle will cause it to move significantly, so although the position has been measured accurately, the velocity of the particle will have been altered. By learning the position, you have rendered any information you previously had on the velocity useless. In other words, the observer affects the observed.
The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.
The Fed cannot change the primary trend in interest rates. However, the Fed can exaggerate the trend, temporarily slow it, or hold the trend for an unreasonably long period of time after the market (without Fed distractions) would have acted. This leads to various distortions, primarily in the direction of the existing trend.
A good example of this is the 1% Fed Funds Rate in 2003-2004. It is highly doubtful the market on its own accord would have reduced interest rates to 1% or held them there for long if it did.
What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.
The Fed has so distorted the economic picture by its very existence that it is fatally flawed logic to suggest the Fed is simply following the market therefore the market is to blame. There would not be a Fed in a free market, and by implication there would be no observer/participant feedback loop.
Fed Uncertainty Principle
The Fed, by its very existence, has completely distorted the market via self-reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication, there would not be observer/participant feedback loops either.
Corollary Number One
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.
Corollary Number Two
The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.
Corollary Number Three
Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.
Corollary Number Four
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.
Additional 2008 Comment
The above text is as written in April of 2008. Here’s an additional comment worth discussing.
Would the market on its own accord be setting rates at the current Fed Funds Rate of 2.25? It’s possible, but there is no way to tell.
It’s even possible the Fed is behind the curve by not acting fast enough. This is of course all guesswork. I don’t know, you don’t know, and the Fed does not know what to do. This is part of the “Fed Uncertainty Principle” and a key reason why the Fed should be abolished. After all, how can you give such power to a group of fools that have clearly proven they have no idea what they are doing?
Big Swift Kick in the Pants
My mom had a saying she frequently used when one of the neighborhood kids was doing or saying something she did not like.
Mom also used the same expression when she wanted someone to speed up what they were doing.
Mom: So and so “Needs a Big Swift Kick in the Pants“
That is exactly what happened yesterday when St. Louis Fed President James Bullard stated in a Bloomberg video:
“I’d like to see 100 basis points in the bag by July 1. I was already more hawkish but I have pulled up dramatically what I think the committee should do.”
Forward Guidance
It’s possible Bullard was stating that on his own. But more likely it’s an admission by the Fed that it finally realizes it’s way behind the curve.
Prior to yesterday, the market was only pricing in a 20% chance of a double rate hike.
Bullard, most likely with Powell’s approval, thought the market needed a big swift kick in the pants so he delivered one.
Market participants, having been given a big swift kick in the pants, took the ball and ran with it. So now the average expectation is for at seven quarter-point hikes this year with significant chances of even more aggressive policy.
Fed Chair Jerome Powell, and former chair Ben Bernanke and Janet Yellen are big believers in using “foreword guidance” as a tool.
Guidance and Belief
Think of foreword guidance as a swift kick (big or small).
The Fed tries to avoid the big kick if it can. But yesterday, the Fed wanted to get expectations to a half-point, thus Bullard’s big swift kick.
The Fed can now walk down or up what it believes it will do.
The Fed still has no idea what’s it’s doing. It cannot see the recession on the horizon nor can the Fed see the stock market bubbles it has blown.
If you think the Fed knows what it is doing, you are mistaken.
This post originated at MishTalk.Com.
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Mish
higher, average annual interest costs would increase by $187 billion.
Interest payments would total $7.3 trillion over the FY 2022 to 2031
period, and federal deficits would increase (with revenue effects) by $209 billion per year.” That would make interest payments higher than the current Medicare budget – with just a 1% increase in rates.