The Fed's Circular Mess

Market volatility is back. The Fed put the end of QE in play, and as a result, big moves in risk assets have become the norm. The market’s reaction over the past several weeks has brought a disturbing question to the surface…how is the Fed really going to get out of the mess it has put itself in? During his speech about QE2, Chairman Bernanke said the point of his policy was to keep “asset prices higher than they otherwise would be.” If it sounds like he was trying to artificially inflate asset prices, that’s because he was…and he did. The market has been on a remarkable tear since the fall of 2010, with only a few minor speed bumps along the way, but is it sustainable once tapering begins?

Perhaps the best way to assess this question is through the lens of causality and logic. I spend a lot of time working in Excel. If you’ve done the same, chances are you have at some point encountered a nasty message saying Excel doesn’t know what it is you’re trying to tell it to do? Often times the cause of this problem is a circular argument. A circular argument is one that uses the conclusion as one of its inputs. Basically, it means that you are messing up causality. So does the Fed’s QE program suffer from messed up causality?

It seems at first glance that artificially inflating asset prices to get the economy to recover to a point that can sustain the level of asset prices does, in fact, seem to fit the bill of a circular argument. Thus, Excel wouldn’t know how to handle such a problem, at least initially (Excel can use trial and error to find a solution). Excel is logic based. It doesn’t know how to deal with the illogical. Thus, either the Fed’s policies are flawed (based on logic) or they are subject to some sort of illogical wonder (magic or pure brilliance). So which is it?

Getting back to Excel, when you use iterations to solve a problem you are basically using many different trials to find a solution (hundreds if not thousands). Many times there is a single outcome that will satisfy the equation. Sometimes there is no solution. Excel can find the answer in a matter of seconds, but when you translate this to the Fed, it doesn’t have this luxury. Its policy impact is not immediately felt. In fact, it may take years to determine if its policies actually worked. Thus, Bernanke and Co. had better get it right the first time.

From a probability perspective, the chance of getting it right the first time is quite low. The Fed is trying to achieve the right amount of stimulus to push the economy into “escape velocity” without causing massive inflation. Getting it exactly right is nearly impossible. Granted, the Fed doesn’t have to get it exactly right. It just needs to be close, but still, that’s a tall order.

If we assume the Fed has a good sense of what level of stimulus is needed to get the job done (a generous assumption), which side of the line will they likely err on? My gut tells me the Fed would much rather deal with inflation than a weak economy. Inflation is relatively easy to combat. It can be chocked off by tightening rates. This is synonymous with pulling on a string. However, battling deflation is much more challenging, and as the old Wall Street adage goes, it is tough to “push on a string.” Thus, I believe the Fed will err on the side of stimulating too much.

So when does the Fed actually start to pull back on QE? The market has been paying particular attention to the unemployment component of the Fed’s mandate, especially the new 7% threshold. However, inflation is equally important, if not more important. James Bullard of the St. Louis Fed blasted the market’s initial reaction to Bernanke’s testimony, basically saying we are missing the point on inflation. Bullard stated the Fed “must defend its inflation target when inflation is below target as well as when it is above target.” With core PCE hovering around 1%, Mr. Bullard is saying the Fed may need to do more to push inflation higher, not less. Now, Mr. Bullard is only one voting member, but he is not considered a policy dove (meaning highly supportive of excess stimulus). Other dovish members of the federal open market committee may be even more inclined to keep QE going.

Most economists expect weaker economic growth and lower inflation than what the Fed is forecasting. With centrist members of the Fed such as James Bullard already sounding caution on the end of QE until policy objectives are met, it is quite possible that when September arrives inflation rate may be too weak to pull back on QE. While the market may cheer this news initially, its staying power is limited.

The Fed’s balance sheet cannot expand forever. At some point, the Fed and the market will come to the realization that quantitative easing is a circular argument without a solution. This becomes more probable as each month passes without a marked increase in economic growth. The Fed’s balance sheet has expanded by 280% over the past five years and the market’s patience is growing thin. Markets like round numbers and my sense is that confidence will begin to wane once the Fed’s balance sheet hits $4 trillion dollars (without signs of self-sustaining economic growth), which at the current pace is about six months away (year-end).

The end of QE is coming one way or another. The market could defy logic and continue to move higher despite a pullback in QE, but if the assumption of causality is correct and asset prices are where they are today because of QE, when the support is removed prices will fall. How far prices fall is yet to be determined. If prices marginally correct (5%-10%) and the market finds its own footing, perhaps the strategy wasn’t flawed and a sustained economic recovery is ahead. If this occurs, Mr. Bernanke will go down as one of the all-time economic heroes. However, if prices fall to the point of weakening economic data and spook the Fed into action again, the result could be far worse. While the end of QE for the right reasons will be a challenge for the markets, that challenge is far more preferable than having to deal with the impact of QE coming to an end due to a realization that it was an iteration that didn’t work. Thus, let’s hope the Fed’s forecast is correct and that growth and inflation are on the horizon.

© HighTower Advisors

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