First, the Fed’s ideas on the current state of affairs, from the minutes of its October meeting of the Open Market Committee:
The Committee expected that, with appropriate policy accommodation, economic growth would pick up from its recent pace, resulting in a gradual decline in the unemployment rate toward levels consistent with the Committee’s dual mandate. Members generally continued to see the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall. Inflation was running below the Committee’s longer-run objective, but longer term inflation expectations were stable, and the Committee anticipated that inflation would move back toward its objective over the medium term. Members recognized, however, that inflation persistently below the Committee’s 2 percent objective could pose risks to economic performance.
That first quoted sentence just kills me, “…with appropriate policy accommodation, economic growth would pick up from its recent pace, resulting in a gradual decline in the unemployment rate toward levels consistent with the committee’s dual mandate.” Translated: We believe that indeed we are the saviors of the economic world. Hubris, much?
And how, exactly, is it that “inflation persistently below the Committee’s 2% objective” poses risks to economic performance? Inflation, as Milton Friedman so poignantly and repeatedly observed, is a monetary phenomenon. It is a matter that lies outside of the demand curve. It is prices changing because money is declining in value. It has, or should have, nothing at all to do with economic performance, the economic system being that place where goods and services are traded for other goods and services through the medium of money. The notion that low inflation, or even deflation, is a bad thing encapsulates and expresses in full the hubris contained in the first quoted sentence. The Fed thinks it controls inflation, and thereby controls real economic outcomes. It does control inflation, but real economic outcomes are only impacted in the short run. As soon as economic actors figure out what real prices are doing, they act accordingly. And if there were none of the Fed’s policy accommodations, real prices would be doing what real prices do in the face of stagnant demand and relentlessly improving productivity–they would be declining. That they are still going up, if weakly, speaks to the massive amount of ‘policy accommodation’ in which the Fed has been engaged.
The ten-year Treasury bond lost 9 basis points after the release of the Fed’s minutes, mostly people believe because of the observation highlighted in bold:
During this general discussion of policy strategy and tactics, participants reviewed issues specific to the Committee’s asset purchase program. They generally expected that the data would prove consistent with the Committee’s outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months. However, participants also considered scenarios under which it might, at some stage, be appropriate to begin to wind down the program before an unambiguous further improvement in the outlook was apparent. A couple of participants thought it premature to focus on this latter eventuality, observing that the purchase pro-gram had been effective and that more time was need-ed to assess the outlook for the labor market and inflation; moreover, international comparisons suggested that the Federal Reserve’s balance sheet retained ample capacity relative to the scale of the U.S. economy.
All it took was a whiff of potential tapering, and bond prices crashed. A 9 basis point increase in a 2.70% interest rate is an increase of three percent. Bond prices move inversely to interest rates. Do the math as to the carnage. Had the Dow gone down proportionately, it would have dropped over 400 points. Stocks lost too, but at a piddly quarter to half a point. But stocks really will tank if and when the markets lose faith in the Fed, and long Treasuries increase by a hundred or more basis points, as they did after May’s meeting.
The Fed seems to think it can exit quantitative easing whenever it wishes:
In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases.
It may have been the observation that “asset purchases are not on a preset course” that really rattled the markets. Ms. Yellen better start preaching accommodation. If she doesn’t soon, the riotously overbought markets (see this Bloomberg piece) will implode.
And if she does, the same ol’ same ol’ will eventually yield a crash to make the Great Recession pale in comparison.
These geniuses who rule our economic lives aren’t really that at all. If they were, they wouldn’t have the financial and economic systems so delicately poised on the edge of a precipice, with no means of safely backing away.