Tuesday, June 19, 2012

Conserving (Monetary) Ammunition

With currently weak economic growth, some are calling for more action by the Federal Reserve to help markets, whether in the form of "Operation Twist" or QE3. Given the weak market response to past Fed actions, I'd say that optimism should be tempered with reality. But, there's a deeper issue at stake: how will the markets react if the Fed has obviously expended all its options?

This MSNBC article scratches the surface of the issue:
...troubles in Europe shouldn’t factor too heavily in the Fed’s plans this week, said Dino Kos, a former New York Fed executive vice president. Weakness in Europe should already be factored into the Fed’s forecast, he told CNBC.
“It shouldn’t really affect their thinking, although the situation has obviously gotten worse,” he said. “The way it should impact their thinking is does the European slowdown affect U.S. growth, and does the growth then come down to such a degree that they need to counter it?”
Kos said the best position for the Fed this week would be to hold fire, given the potential negative consequences of the fiscal cliff.
Do you want the Federal Reserve to have something in reserve?” he said, noting that there are many uncertainties surrounding the fiscal cliff, given its timing, and the uncertainties about what the political situation will be at the end of the year.
What happens if the Fed taps every resource available, and markets still don't react positively? According to mainstream economic thinking, the economy will probably continue to grow sluggishly at best, or if there is another crisis of confidence in the future, it will decline. Given this information, investors should short the market now, before the decline starts and that profit opportunity evaporates.

To use a vivid image, think of Clint Eastwood in "Dirty Harry" as the Fed, saying "how many shots did I fire? Was it five or six? I'm not sure, but you should ask yourself... do you feel lucky?" In this case, the bad guys are the short-sellers (although on this point, the analogy breaks down because short-sellers actually provide useful information that certain parts of the market are overvalued, but put that aside for now).

There's still a lot of uncertainty about whether new Fed action will occur and whether it would have any positive effect on the economy, but in this context, that uncertainty is a blessing. Without it, an ineffective Fed policy action could create a self-fulfilling prophecy of economic decline: knowing that future tools will be ineffective and that the market will probably tank in the future, speculators will short-sell now, causing the market to drop immediately. Expectations become reality.

Just like Dirty Harry's potential to have another round in the chamber deters the bad guy, the Fed potentially having another trick up its sleeve might deter short-sellers. If that last "round" is fired wildly, any small positive effect it might have could very easily be swamped by the market's expectation that when the next crisis comes along, the Fed will be flat empty.

Keep in mind, the analysis so far has been assuming that Fed action is otherwise innocuous, and ignores the possibility of inflation or distorting time-specific asset values (which Austrian business-cycle theory would emphasize). Even taken on its own theoretical terms, monetary policy could make economic problems immediately worse.

Bernanke has almost certainly already considered this possibility, which is why we should expect only muted actions from the Fed going forward. At least, so I hope.

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