Has the Fed Failed?

An age-old debate centers on how effective markets are at predicting the future. Those who believe in the efficient market thesis (EMH) are convinced that the markets accurately discount all available information, thus making the current price a true reflection of a stock's fair value. Others take the view that irrational human behavior causes prices to swing to such extremes that they offer little predictive value.

I have never been a true believer in the strict view of the EMH. While markets generally do an excellent job of discounting information, at times prices reach irrational levels. However, the duration and extent of these moves are so hard to judge that investors looking to profit from irrationality face a difficult challenge. Instead, we should assume markets are properly discounting future events and challenge that view only when we have compelling information that points toward inefficiencies.

Hopefully the markets are now approaching a period of irrationality. If not, they paint a dire picture.

While academics will spend years explaining what triggered the current bear market and assessing whether or not policy decisions were appropriate, we know a few things for certain. As markets collapsed into March, fear of future deflation was widespread. In a deflationary environment, prices collapse, assets lose value, and economic activity ceases. After all, if something will be cheaper tomorrow, why buy it today?

Federal Reserve (Fed) chairman Ben Bernanke and many others believe deflation extended the Great Depression and that by preventing it now we could stave off economic Armageddon. Their answer has been to spend money recklessly and expand the Fed's balance sheet in hopes of facilitating credit expansion. On March 18, the Fed began directly buying bonds and leaped down the path of quantitative easing. Immediately, commodities skyrocketed and the dollar weakened. Bernanke, who felt that printing money would thwart deflation, was pleased with the market's reaction.

Now times are changing. The inflation trade which had worked so well in the beginning is now collapsing. Stocks and commodities are falling while the dollar and bonds rally. The broad-based Powershares DB Commodity Fund (DBC) is 16% below its recent high and is showing signs of imminent collapse. Lowry's buying index, a measure of stock market demand, is below the level at which it traded when stocks bottomed in March. With demand waning and prices collapsing, the market is telling us that the Fed's attempt to create inflation has failed.

If this interpretation of the market's reaction is correct, we should be fearful. The Fed has lent or guaranteed nearly $14 trillion. The Obama administration is pouring trillions more in deficit spending into the economy to help jumpstart economic recovery. If these dollars are spent without achieving the desired effect, what is next? The Fed has indicated it will not stop until inflation is created, but there is an eventual limit to its ability to manipulate the markets. It's now looking like we have reached that point and investors should prepare for the worst.

Bear markets never truly end until the last bull has been slain. The recent sharp rally from the March low was atypical of a true bottom and instead presented itself as a tradeable rally. As deflation fears reemerge, prices should work lower. I do not expect the ultimate bottom to occur until the majority of investors have been forced from positions and abandon hope. At that time, those who have remained disciplined and hedged their risks appropriately will be positioned to seize the opportunity and buy stocks at very low levels.

Like all bear markets, this one will eventually end. By preparing for the future, we can act when the time is right.

Comments

[Moon Kil Woong:]

I'd love to see the Fed get audited like a bank which it is and find out how much of it's book has to be written down. If that doesn't make the public scream (since the Fed is backed by the taxpayer just like Fannie Mae and Freddie Mac) I don't know what will. That doesn't include all the junk they backstopped as well. Those are more akin to the Fed taking over AIG's role in writing bond derivatives. After all, both are insuring questionable bonds agains default. Perhaps that's why they have decided recently to scale down their wonderful QE machine before someone demands to see what's under the hood.

Regarding the Fed failing. Considering their #1 job is insuring value and stability of the US$, yes they have. The dollar depreciation over the past 70 years exceeded any other decade comparison. If you argue they are suppose to moderate economic cycles they also clearly have failed. Although we haven't had a great depression repeat the odds of one haven't really diminished and we have financial catastrophes which occur on a regular cycle (about a decade).

Furthermore, their encouragement for the government to keep running deficits so they can gain more power through bond auctions and Congress granting them powers they as a private bank should not have is running us into the ground. When that occurs the great depression may look mild. I hope it doesn't happen in my lifetime, but it's looking increasingly unlikely.

Jul 09 06:11 AM

[Steven Hansen:]

you are viewing this as a technical trader which is good.

the issue is whether the underlying conditions are causing the technical signals to be misread, misinterpreted - or simply are the signals wrong. i am disturbed by the leading indicators projected strength and timing of economic conditions while the coincident indicators failing to respond in a timely manner. i think most investors are also concerned.

there will not be a bull market until investors join the traders in the market.

Jul 09 06:26 AM

[morph366:]

"The Fed has indicated it will not stop until inflation is created, but there is an eventual limit to its ability to manipulate the markets."
As you say the powers of the Fed are being fully tested now and in the coming months we shall find out whether the old adage about "never fighting the Fed" is going to see us pull out of the deflationary vortex which is becoming increasingly like an economic black hole

Jul 09 08:05 AM

[jhartz:]

The Fed will fail. Not just fail in the sense of not accomplishing what it was set up to do, but fail in the sense that it will become insolvent beyond anything we saw with AIG.

They might believe that their ability to print money protects them from any near term accountability, but they are wrong to believe that. Every day, more and more concerned citizens are taking a closer look at what is happening in this country. When enough of the citizenry become anxious about what the Fed is really doing, there will be an audit.

Jul 09 08:22 AM

[AndrewBaker:]

Of course they have failed: by printing and handing out more and more money they are encouraging greater debt that can ever be paid back, certainly not in our lifetimes. The profligate will continue and the savers and prudent people will pay for them with the loss of their own wealth. Nothing about this is making one more widget or sellable item, so nothing about it is increasing any real worth.

Deflation may hold for a while as we are afraid to spend, but inflation when it comes will hurt too as what we do have will be worth that much less in real terms.

Playing with money will solve nothing.

Jul 09 08:52 AM

[Ferdinand E...:]

This is a good article, although another title might have been appropriate. After all, this is a site where a majority of the contributors and commentators automatically believe that the present US government will be wrong in everything they do. Unfortunately for them, however, the people who will vote in the next presidential election may not feel that way. I won't feel that way if Governor Palin
puts in another appearance on the Republican ticket.

Jul 09 09:24 AM

[swaps:]

History does repeat itself.
Congress and the White House and the general public should consider Rober P. Murphy's book, The Politically Incorrect Guide to the Great Depression and the New Deal.
It turns out our schools and the media have been feeding us false information. Hoover was an interventionist. Massive spending by FDR - like Obama is doing now - did not work.
Here's what an Amazon review notes about Murphy's findings:

* The Crash of `29 was caused not by capitalism, but by the boom brought on by the newly created Federal Reserve's easy money policy (sound familiar?)
* Hoover made the Depression "Great" precisely by abandoning the laissez-faire approach that previous presidents had followed and that kept depressions short
* The bank runs of the 1930s were caused by government intervention in the banking system
* Government efforts to prop up wages and prices led to a full decade of double-digit unemployment
* FDR's arbitrary policies toward businessmen resulted in net investment of less than zero for much of the Depression

Jul 09 10:41 AM

[Mark Wallace:]

We have been living for nearly three quarters of a century in the artificial prosperity of a credit expansion. The credit expansion had profound feedback effects which kept it going and artificially boosted the prices of various financial and nonfinancial assets such as stocks, bonds, commercial real estate, multifamily housing and personal residences. Now the credit expansion has ceased, and credit is contracting. The real 64 dollar question is whether the contraction in credit can be reversed by the Fed, Congress or anyone else. I suspect it is beyond anyone's control but that's only a guess. Stretch your imagination a little -- imagine a world where your house depreciates 5 ot 6 percent a year for 10 or 15 years in a row and salaries and wages begin to follow suit.

Jul 09 02:28 PM

[Gregman2:]

"Their answer has been to spend money recklessly and expand the Fed's balance sheet in hopes of facilitating credit expansion. On March 18, the Fed began directly buying bonds and leaped down the path of quantitative easing. Immediately, commodities skyrocketed and the dollar weakened. Bernanke, who felt that printing money would thwart deflation, was pleased with the market's reaction." For one, money has not been "printed" and it's clear that the core inflation rate is still about 1.8%. The Fed has made its mistakes, but not for lack of attention or trying. Letting Lehman fail was a bad move. If anything, the top-down policy approach will not work. But it's hard to definitively say that the Fed has "failed."

Jul 09 02:57 PM

[Fighting Yoda:]

Fed has failed by a wide margin. BB cut rates too early - help create the commodity bubble - the bigger the bubble bigger the collapse. Sine then they have tried everything- helicopter, bazookas,...:
Cheap money - 0% APR
Easy Money - All the programs- TALF,... - dodgy collateral
Free Money - bailouts (AIG,...)

All they have to show after spending Trillions- 9.5% unemployment and deflation.

Jul 09 08:32 PM