Money: Perception Trumps Policy

“Reality is merely an illusion, albeit a very persistent one.” — Albert Einstein

Contrary to popular thinking, central bank actions do not directly impact inflation and economic growth. When the Fed pulls levers to ease credit, this does not automatically produce more credit, especially when there is a lack of creditworthy borrowers. The importance of Fed policy is to shape the common narrative that things are getting better. In this regard, investors’ perceptions of Fed policy are more important than any of the Fed’s monetary tools.

Quantitative Easing only works if enough people believe the Fed possesses the supernatural powers to change the economic future. And the Fed’s ability to accomplish this rests on our belief in their omnipotence, which rests on their ability to convert non-believers to believers. Any marginal market move is the conversion of a non-believer to a believer.

Monetarists mistakenly believe that QE was intended to lower the price of credit in order to promote bank lending and economic growth. This was not the case. The real intention of QE was to display the Fed’s supernatural powers: “Don’t bet against us, because we are powerful enough to buy every bond in existence.” In reality, rounds of QE led to higher interest rates during the program and a fall in rates upon expiry:

The Fed points to lessons from economic history as to what policy could or should have been implemented, however, they too readily dismiss the fact that each economic crisis is different. Not only different in the sense of economic problems faced, but different in the perceptions of economic participants. However, the Fed’s prescription to the dot com bubble was essentially the same as to the financial crisis: lower rates.

This begs the philosophical question: How can the Fed know how to fix the economy if they can’t prove a counterfactual? Before 5 years of ZIRP and $4 trillion of QE, the Fed provided a glimpse at a potential counterfactual by sacrificing Lehman Brothers like the proverbial maiden-in-the-fire. When this 100-year old investment bank was allowed to implode overnight, the Fed stood atop the resulting fracture in the financial markets and exclaimed, “See what happens if you do not appease the monetary Gods!”

The Fed wanted the market to believe that this counterfactual post-apocalyptic world could only be avoided through a divine belief in central bank omnipotence. And thus commenced the process of converting non-believers to believers. Financial markets stabilized through faith in the powers bestowed on the Fed. (Sorry, preppers, there is no need for that underground bunker and stores of freeze dried MRE’s just yet).

After you’ve converted to a believer, you must still contend with the fact that Yellen (and previously Bernanke) are merely a bunch of actors going on stage cold with no script. Bernanke waived the script from the “lost decade” in Japan, but Japan wasn’t facing a do-nothing Congress and an unprecedented structural shift in employment as automation replaces middle class jobs. The central bank actors improvised through their skits in an attempt to make the current audience feel better about their financial futures, never wondering whether or not they’ve ruined the future for tomorrow’s matinee audience. Or will there even be a matinee performance tomorrow if the Fed bombs tonight?

The Fed is performing the greatest kabuki dance in the history of the mankind. If the audience starts to boo, Yellen and friends dance and ease more vigorously. They’ve learned this behavior through trial and error. Before QE2, the audience was lined up with rotten tomatoes and shepherd’s crooks. The inflationistas screamed about runaway prices and the return of Weimar Republic-like inflation. The sitting governor of Texas, Rick Perry, called Bernanke “treasonous” and claimed that he would “treat him pretty ugly down in Texas.” The Fed not only carried on with their QE2 kabuki dance, they also queued up and unleashed the Kraken QE3 at the first sign of financial distress (as observed in a market selloff). So far, inflation remains at a subdued pace of 2%. Rick Perry and the inflationistas dine on crow.

However, this economic leviathan ain’t grandma’s run-of-the-mill recession that was remedied with a serving of lower interest rates sprinkled with a few tax cuts. Rather, the economy now faces the deleveraging bogeyman where debtors choose to pay down debt faster than others attempt to borrow. And if we learned anything from Keynes, when everyone attempts to save at the same time, everyone is fucked. Deleveraging means you can throw policy guidelines like the Taylor Rule out the window (as if there was ever a magical heuristic to describe human behavior).

The deleveraging episode has a potential binary outcome: either society chooses to pay down its debt and save OR society continues to withdraw credit and spend. The former would result in a sharp drop in asset prices and the implosion of overleveraged TBTF banks. This would surely commence the Great Depression Part Deux. America would fall into a savings trap, where total savings declines because everyone is trying to save at the same time. (My savings is your spending and vice versa).

The latter scenario means more credit, higher asset prices, and an abundance of moral hazards. In other words, 2004–2007 business as usual. Remarkably, the Fed has managed to orchestrate this latter scenario over the past 5 years by converting non-believers into believers of central bank omnipotence.

But it’s anyone’s guess as to how long people will remain believers.