The Aura Of the Fed Is Gone, Good Riddance

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In the wider financial discussion of where we are and where we are going, I think it is safe to say that we are at the end of an era. Not just in one specific aspect, but across a broad spectrum of how we see the world and how we attempt to operate within it. This will not be a smooth transition or change, fundamental shifts never are, but, though there is chaos and economic heartache just over the horizon, the comfort we may yet earn is also at hand in a new beginning based on sound principles and freedom.

We are likely witnessing the beginning of the end of modern monetary thought. Though it is very tempting to say that Emperor Bernanke has no clothes and stop there, that limited statement of truth diminishes the wider transformation under way. The reality is that for the past forty years the Federal Reserve has grown to dominate both the markets and the economy in ways never contemplated at any point during that time. In the process it has gained a mythical status amongst investors and the larger population, and not just in the United States.

The mystique of the Fed, upon closer examination, is just that. If we analyze monetary policy through the decades with a critical eye, we see that the Fed's only true gift is public relations. Its reputation has been earned only through managing expectations and cultivating alternate visions of reality (see the term Great Moderation). In doing so, it attracted undying loyalty and adulation, as well as unabashed fear.

It is a well-known and well-worn trope that you don't fight the Fed, it will run you over no matter how right you think you may be. This cliché is an extraction from Keynes and his observation that the markets can stay irrational longer than you can stay solvent. In our modern world, the Fed has become the irrational market, backed by the supposition of unlimited money printing.

In essence, that was what QE 2.0 really was. Further "proof" that you do not dare challenge monetary policy. If you happen to express a contrary outlook through your investments, such as shorting, you will get steamrolled by the monetary inspired marketplace.

That sentiment has spawned all sorts of stories about monetary might, including the ever-present Plunge Protection Team. Though I do not doubt the Fed has a lot of interventions to explain in its $136 billion "other assets" line on its balance sheet, we have yet to see the PPT actually stop a plunge, especially since it is now 0-3 in the last three years alone. Instead, the Fed really is a paper tiger, limited to fostering an image through the innumerable 2am U-turns (always in the up direction) that stock futures exhibited throughout the QEs. The Fed may be able to impose its will during the most illiquid markets, but has yet to demonstrate real, direct strength during the cash markets. But as long as investors believed there was real strength behind the bluster, its bidding was always carried forward.

All of these myths and stories and tropes have served a singular purpose: to fulfill the rational expectations theory. Current monetary policy and theory holds that the rational expectations theory was one of the biggest advances of the past seventy years. Essentially, it means that if the Fed can convince investors/consumers that conditions will be what it wants them to be tomorrow, investors/consumers will act accordingly today.

Think about the implications of such a powerful theory. The Federal Reserve, through interest rates and other policies in its toolbox, can alter the trajectory of the markets and the economy simply by "managing" future expectations. And of course, if the Fed wants you to believe the markets will be better in the near future, its work is much easier if investors believe it is futile to stand in the way. Resistance, swept aside by the myths, clears the path to successful policy expeditions and interventions. The economy can be managed by the "scientific" and "benevolent" process of bullying.

This brings to mind the HBO series, "Band of Brothers". A platoon commander from another company, Lt. Ronald Speirs, was believed to have taken part in some vicious and amazing acts during the European war just after D-day. Only a few "witnessed" these acts, yet the stories became widely known, earning him a tough and often fearful reputation.

During the hell of the Bastogne campaign, Lt. Speirs was elevated to command to replace a weak and ineffective leader. In a quiet moment of reflection after a serious engagement, he spoke about an element to those stories that was far more revealing about the desperate nature of necessary control:

Speirs : You wanna know if they're true or not, the stories about me? Did you ever notice with stories like that, everyone says they heard it from someone who was there. Then when you ask that person, they say they heard it from someone who was there. It's nothing new, really. I bet if you went back two thousand years, you'd hear a couple centurions standing around yakkin' about how Tertius lopped off the heads of some Carthaginian prisoners.

Lipton : Well, maybe they kept talking about it because they never heard Tertius deny it.

Speirs : Maybe that's because Tertius knew there was some value to the men thinking he was the meanest, toughest son of a bitch in the whole Roman Legion.

Such a reputation is obviously useful in the military context of mortal conflict, but there should be hard questions about adapting this kind of rigid command structure within a free economic society.

The Federal Reserve, resting the fate of the entire economy on its ability to carry forward under the rational expectations theory, needs to have these myths. Just like the battles that awaited Lt. Speirs and his charges, the Fed must command enough respect to get skittish and worried investors to put their money into the system, rather than take it out and run as their intuition tells them. Any challenge to that authority puts wider tactical and strategic goals in desperate jeopardy. Bernanke is not just naked, the Federal Reserve, in comparison to the size of financial markets, has absolutely no direct power. It can give commands, but, in the end, the market can choose to ignore and overwhelm them, or follow them blindly. If the market fears the Fed, it is far less likely to challenge that perceived authority.

The decline in stocks began after the July GDP revisions showed that economic growth the Fed promised it would create as a result of QE 2.0 was as much an illusion as its reputation. The Fed pledged direct results, but consumers just have not obeyed the orders.

The markets, awakened by this stunning reversal, finally are cluing in to the fact that the "Bernanke put", just like the "Greenspan put" that came before it, was nothing more than lore - it was a bewitching figment of the minds of traders. The stories of Fed power were given substance by traders acting out of fear that it might be true.

As much as the political sphere wants to make this recent market action about the debt, it is all about the economy as it relates to monetary policy. The dance of demurring debt captured the minds of commentators, but it was a misplaced focus. The federal government's debt is but a symptom of the wider monetary disease. Where would that debt be without artificially favorable interest rates? Isn't it more likely that the federal debt would have remained far more modest had interest rates been dictated by the markets? A regulating interest rate regime would likely have forced the government's hand far sooner as interest costs ate away a significant portion of discretionary spending. The federal government's worst fear today would have already been reality had the Fed left interest rates free to price risks.

The rot at the core of our current predicament is solely a product of monetary imbalance and miscalculation. In practical terms, the point of exact failure of convention is that prices are thought to uniformly foster those rational expectations. The Fed, as well as central banks around the world, fully believes that it can turn price discovery into stability. Essentially, control of the financial system gets interjected into the wider economy largely in the subset of superficial, not actual, stability.

As an example, the tech bubble of the late 1990's was nothing more than out-of-control asset inflation created by over-stimulation of credit. Yet, the economy continued to allocate resources and activity toward the locus of instability precisely because the Fed had achieved its mythical status. Common sense was overridden by the belief that the "best and brightest" were in "control", so nothing bad could or would happen.

Despite being a period fraught with intrinsic instability, the dot-com bubble became the first glaring example of artificial stability created through the interconnection of "rational" expectations and mythical genius. Greenspan was lauded as the financial Tertius, who defeated not only market instability, but had completely changed the economy by conquering the business cycle (the ridiculous talk of a "new normal"). None of it was true, but as long as investors believed it and feared countering it, the myth became economic and market reality - the paradox of a stable instability.

I have described this previously as nothing more than a modified "pump and dump". The "pump and dump" scheme can only work as long as the perpetrator displays some kind of credibility. For central banks, that meant prices and artificial price discovery, and it required destroying dissent. But something has changed post-2008. The economy did not simply respond to rational expectations since realized prices have not flowed through to economic expansion, and thus has created so much puzzlement following those GDP revisions.

Despite persistent efforts to get credit flowing, households and businesses (outside of large multinational firms that are taking advantage of willful dollar destruction) refuse to return to 2007. Through common sense, for the most part, they have made the rational decision to allow their personal balance sheets to be dictated by fundamental income and real savings rather than the temporal exposition of asset prices. The larger monetary flaw is exposed.

The defect is not just that the mathematical models economists have become too dependent on cannot predict anything other than a straight line. Rather, it goes all the way to the core of modern beliefs, this all-encompassing idea that an economy cannot set its own course, or even its own parameters. The progress of scientific thought has morphed into the hubristic notion that the utterly complex and often esoteric idea that an economy is better off if it is "managed". In other words, central bankers know better than the billions of opinions that are exchanged in transactions every day. The Federal Reserve's idea of a healthy economy and how to achieve it is now in direct conflict with the denizens of the United States.

This fault remained hidden for so long simply because monetary destruction does not appear as such. Asset inflation, otherwise known as asset bubbles, is welcomed by everyone, at first. Investors love rising asset prices, whether they have fundamental justification or not. And when prices get so far away from fundamentals, the Federal Reserve's mythological reputation gives rise to and solidifies rationalizations that serve to insulate and contain the inflationary feedback loop from its natural state: collapse.

At this point there can be no stability. Central policy decisions cannot impose a solution no matter how much money is created, borrowed and then wasted. I have been saying for several years that monetary policy is trying to take the economy in a direction it does not want to go; that true economic potential does not lie in wisps of asset prices and interest rates. Money itself is the problem, as it has become nothing more than the mechanism to describe and transmit financial and economic control through willing adherents and fearfully withdrawn dissenters. The bubble cannot naturally collapse as long as nobody wants to challenge the rationalizations with direct action.

A renewed recession is the most powerful, direct evidence (not belief) that monetary policy cannot achieve its goals. If the Federal Reserve could be so wrong yet again, investors/consumers/businesses will rethink their allegiance to it. That will essentially destroy any command/control that the Fed wants to carry out through artificial prices, severing the vitally important link to rational expectations. This has been the case since 2007 (perhaps 2006) but as it becomes widely known and accepted, monetary policy grows still weaker.

The economy needs to be returned to its foundation of capital allocation, free from constraining intervention. Stability is found there, under the cover of market discipline and real price discovery. There is no happiness at the end of the paper chase since sustainable enterprises never follow from it. In the end analysis, monetary policy tries to control the economy by being intentionally backwards.

The innovation and growth that any economy needs comes from fostering good ideas. Capital allocation to good economic ideas is made difficult wherever prices are artificial and the Fed occupies its pedestal. In an environment of fast rising asset prices and short-term paper profits, not enough capital unintentionally filters to those best, innovative ideas. Instead, plentiful capital simply chases the same artificial prices, badly allocating resources along the way as every bad idea gets funded. In a capitalist, balanced system, prices flow from the success of productive endeavors, not the other way around.

Whatever crisis follows, this could be, as I said at the outset of this piece, the beginning of the end of the Age of Monetarism. Our economy, including the rest of the world, needs to see the Federal Reserve and central banks stripped down to reality. Monetary policy needs to be exposed as a broken, flawed theory consisting of nothing more than hubris and harmful ideas. From there, we can try to regain a fundamental capitalist footing that ensures long-term economic health.

Human nature is unfortunately very sticky on the point of fundamental change, and far too often dramatic collapse is required to push the apathetic body politic to demand real change. What we have here is an opportunity to reinvent ourselves in the mold of those that made us great. Our country was not founded on the idea that the economy can and should be controlled through money.

The entrenchment of current thought and philosophy should not be overlooked or underestimated. The Federal Reserve will not change on its own since it has a very established pattern of always doubling down on its mistakes. What is most worrying is that another crisis just might be accepted as another chance to disprove its now obvious flaws. In that terrible case, a third crisis will be required, as surely another turn at conventional policies will end just as they have always ended - in economic hardship and systemic impoverishment harvested from the willing erosion of economic freedom. In that case, we will have only ourselves to blame since the Fed has no real power.

Abraham Lincoln said it best of a free society, "If destruction be our lot, we ourselves must be its author and finisher. As a nation of free men, we must live through all time, or die by suicide."



Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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