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Minyan Mailbag: What Can Stop The Fed?

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Rather than eyeing the Fed, savvy market participants may be better off looking for social cues that suggest collective risk aversion.

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Dear Matt,

First of all, thanks to all of you at Minyanville, I've been reading for over a year now and am learning a lot!

But I have a question about The Liquidity Addiction: What would stop the Fed from pumping liquidity into the system? It seems to me that there will always be elements of moral hazard and money jumping between asset classes searching for return, but the Fed does have a choice.

What kinds of things would lead them to change or continue their behavior? It seems that you can't judge the risks without some ideas about triggers. I know about watching the Fed and the detailed interpretation of the minutes, but I am wondering about the larger picture of Fed triggers.

Thanks for all your efforts,
Minyan Sandy



Minyan Sandy,

Glad you're enjoying the 'Ville. I try to read every word written on Minyanville each day and, like you, I'm constantly learning.

Regarding your question, "What would stop the Fed from pumping liquidity into the system?"

One motivator could be increases in the prices of goods and services (such as those approximated by the Consumer Price Index) that the Fed deems excessive. Because part of the Fed's charter relates to 'price stability,' large increases in the CPI might prompt the Fed to remove money and credit from the system, which could decrease liquidity-driven demand.

Skeptics, however, doubt that the Fed has the stomach to do much of that-particularly in a highly levered system like in the US that depends on low interest rates. And history is on the skeptics' side. Since its creation in 1913, the Fed has largely been an inflation machine.

Another mechanism for reducing liquidity may not be in the Fed's control. It's a factor that you'll find discussed in very few venues besides Minyanville. Although the Fed might always offer liquidity, what if market participants don't want it? Particularly as it relates to credit, what if lenders, borrowers, or both decide that they don't want any more?

What could cause such a phenomenon? Perhaps overextended consumers decide that they can't borrow any more, and begin saving and paying down debt. If housing prices continue to crumble, perhaps financial institutions curtail lending in order to manage losses in their loan portfolios.

Whatever the cause, the important thing to note is that a reduction in liquidity may not be in the Fed's control. It may be a social phenomenon driven by a collective psychology of risk aversion and appetite for credit (plus #5 here).

The credit contraction which would ensue is the essence of deflation. Ironically, the more credit that is created through intervention, the more the downstream consequences may be deflationary.

There are precedents in this regard. The Great Depression can be viewed as a social movement towards risk aversion, as can the Japanese economy from 1990 until relatively recently.

One reason why this idea is so interesting is that conventional wisdom views inflation (and deflation) as a monetary phenomenon. More accurately, however, inflation and deflation may be better viewed as a social phenomenon (driven by risk taking or risk aversion).

So, rather than eyeing the Fed, savvy market participants may be better off looking for social cues that suggest collective risk aversion.

Best regards,
Matt
No positions in stocks mentioned.

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