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Fed Uncertainty Principle


Do central banks really set interest rates?

Most think the Federal Reserve follows market expectations. Count me in that group as well. However, this creates what would appear at first glance to be a major paradox: If it's 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.

For example: If market participants are expecting the Fed to cut on weakness and the Fed does, market participants gets into a psychology of expecting more cuts on more weakness. Here is another example: If market participants expect the Fed to cut rates when economic stress occurs, they will takes positions based on those expectations. These expectation cycles can be self reinforcing.

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 it 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's 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.

In a free market it would be highly unlikely to get a yield curve as steep as the one in 2003 or as steep as it was just weeks ago when short term treasuries traded down to 0.21%. In other words we would not be in this mess without the Fed, or if we were, the mess would at least be smaller than the one we are in.

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 doesn't know what to do. This is part of the "Fed Uncertainty Principle" and a key reason why the Fed should be abolished.

The Fed has so distorted the economic picture by its very existence that it's 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.

The Fed hints at "possibility" of recession. We are already in one.

Today's headline reads Bernanke Nods at Possibility of a Recession.

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

My Comment:
Bernanke is passing the buck. If housing continues to collapse Bernanke will attempt to blame Congress rather that point the finger at the number one culprit in this mess: The Fed, for micromanaging interest rates and blowing bigger bubble after bigger bubble.

Mr. Bernanke, testifying before the Joint Economic Committee on Capitol Hill, said the economic situation had weakened since the Fed last reported at the end of January but that it could revive later in 2008 because of the $150 billion spending and tax cut package enacted this year.

"It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly," he said. "We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies."

My Comment:
Bernanke clearly does not understand what's happening, or if he does, he's not telling the truth about it.

Uncertainty Principle 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.

According to America's Research Group "Seventy percent of consumers who have received their 2007 income tax refund are using it to pay off credit cards and bills, the first time in 20 years that figure has topped 50 percent." See March Auto Roundup And Retail Sales Forecast for more on this topic.

Think you are going to get stimulus out of Bush's stimulus plan? Think again.

In separate comments, Mr. Bernanke went further than he had in the past, suggesting that the Fed would remain aggressive and vigilant to prevent a repetition of a collapse like that of Bear Stearns, though he said he saw no such problems on the horizon.

My Comment: Supposedly the Fed couldn't see the possibility of a derivatives chain reaction coming until after it started, even though this has been openly discussed in the news media for years.

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