The Fed Isn't 'Stupid,' The Market Is: Understanding Monetary Policy 101

by: Robert Wagner

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"The message right now from the markets is plain and simple that the Fed is stupid."

That is a quote from this video as Rich Bernstein, CEO of Richard Bernstein Advisors, tries to explain the philosophy currently driving the market. He explains that the markets seem to believe that the Fed will raise rates prematurely, and then goes on to explain that the Fed is always late when it comes to raising rates. Both he and Ron Insana lend support to the Fed, stating that they don't believe the "Fed is that stupid."

I would argue both Ron and Rich are 100% correct, and that it is the market that is stupid, not the Fed. I've studied, taught and practiced finance and economics for over 30 years and have been horrified by the comments and attacks on the Fed since 2008. The Fed was created to be the "lender of last resort" in order to prevent the financial and banking system collapses that used to plague our economy. In my opinion the Fed has acted in a textbook manner and has performed exactly as it should have. Since 2008, whenever a decision was made by the Fed, I would always find myself thinking "good, that is exactly what I would have done if I ran the Fed, and Ben is doing precisely what the textbook says he should do."

The problem is that monetary policy isn't simple to understand, and when I was in school, International Trade and Monetary Policy was a 600 level class, and offered in the economics, not finance, department. Very few of the people I knew that were getting into finance were economics majors, and fewer still took economics at the 600 level. To make things even more difficult, much of economics is counter intuitive, and economic theories are based upon "ceteris paribus" or "all else held equal." In the real world, ceteris paribus conditions never exist, not even for a millisecond, so every economic comment and analysis had to be put into context. This unfortunately leads to situations like we see today in gold or the SPDR Gold Trust (NYSEARCA:GLD), where people are buying gold fearing inflation, when in reality deflation is a greater threat. Context is everything, and while "printing money out of thin air" may be inflationary under some conditions, as the current situation proves, "printing money out of thin air" may not drive prices higher at all. I've found myself adding comments in my articles identifying that I am aware that some of my economic comments appear to make no sense and are contradictory, but put in the right context they make perfect sense.

That last statement isn't contradictory, much like we have the freedom of speech, but we can't simply cry fire in a crowded theater. There are rules by which the Fed operates, so yes theoretically they could "print money out of thin air" until the cows come home and cause inflation like the critics feared, but practically they can't.

After endlessly debating and writing countless commentaries on this topic I think I have finally found a way to explain monetary policy and the concepts discussed in the above linked video. Some of this may sound like it contradicts itself, but it doesn't if it is put in the proper context. The problem the markets have with monetary policy is that its impact isn't consistent. An analogy would be a marathon runner that passes out during a run. If it was due to dehydration and exhaustion, the treatment would be to give the person water and a candy bar. If it was due to a diabetes caused heart attack, CPR would be needed, and water and a candy bar would only complicate things. Different treatments for the same observation can have dramatically different results, and must be put into context of the patient's true condition.

The first misunderstanding of monetary policy is that the Fed controls interest rates. This is wrong for various reasons:

1) The Fed does nothing of the sort. This is proven by the fact that interest rates continually adjust to market forces, and the yield curve normally slopes upward. If the Fed controlled interest rates the yield curve would be static, and only change when the Fed decides to change it. What the Fed does do is control one single interest rate, the ultra-short overnight discount rate. All other rates, including the Fed funds rate, are market driven. What ultimately controls interest rates is inflation. If inflation develops, interest rates will increase, and there is nothing the Fed can do to stop the increase in rates from happening. The Fed simply has no power to force an investor to buy a bond at a negative real yield. That isn't to say you can't have negative real yields, it just says the Fed can't create that situation. The markets do it under their own free will. The Fed can however implement a strategy that will lower inflation, which in turn lowers interest rates, but inflation ultimately determines interest rates, not the Fed.

2) With QEfinity the Fed broke from traditional monetary policy and extended its bond purchases out along the yield curve. The Fed used to only buy short-term treasuries, and now they are buying non-treasury mortgage back securities (MBS) and the 10-year treasury bonds. The Fed balance sheet is over $3 trillion, but even if 100% of that was invested in MBSs and the 10-year treasury bond, it would barely put a dent in the yield curve, as demonstrated above in the graphic. The US debt is over $16 trillion, mortgage debt is $13 trillion, so at best one can argue that the Fed's QE has the ability to influence, not control, the long end of the curve. When and if the economy recovers, the 10-year and mortgage rates will increase on their own, regardless of what the Fed does. This graphic of the current yield curve proves that there is no abnormal dip at the 10-year where the Fed is buying, and the yield curve looks pretty much normal outside the fact that because of the anemic economic growth and high unemployment, it is much lower than it is historically.

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3) The Fed has the ability to put a "price floor" in the ultra-short term over-night lending discount rate. A price floor simply prevents rates from falling below it, there is nothing in the Fed's power that can prevent an interest rate from increasing. Yes, as mentioned above, QE can attempt to influence the rate, but the Fed has no power to prevent markets from increasing rates on their own if market conditions justify it. That is why the Fed is almost always late, the markets have self adjusting mechanisms which are usually best left alone. If the economy is over heating, interest rates will adjust naturally. Only when the markets don't appear to be slowing enough to contain inflation does the Fed typically step in and take the punch bowl away. The key is, the party is already rocking before the Fed steps in and pours cold water on the fun. Ironically, because a price floor doesn't prevent markets from reaching their equilibrium price as long as the floor is set below the equilibrium price, by the Fed setting the target rates at 0%, it is effectively allowing the markets to set the rates for the entire yield curve...with the Fed only "influencing" the mortgage and 10 year rates. Supporters of the free market should love what the Fed is doing right now because the vast majority of the yield curve is market determined.

When a "price floor" is set, a certain minimum amount must be paid for a good or service. If the price floor is below a market price, no direct effect occurs.

The second misunderstanding is that monetary policy is stimulative and will lead to inflation. That is the misunderstanding that has lead many Fed critics to buy gold. Monetary policy can be stimulative, but at other times totally ineffective - it depends on the context. The cliche "you can lead a horse to water, but you can't make it drink" best defines how monetary policy works. The Fed by lowering interest rates, can make it more attractive for people and businesses to borrow, spend and invest, but it has no way to force them to do that. Monetary policy is often described as "pushing on a string." Monetary policy is a carrot that relies on voluntary behavior, whereas its more forceful twin fiscal policy is a fist.

The best analogy I can think of to explain the varying impact of monetary policy on inflation is a coasting car that is going up and down hills like a rollercoaster. In that analogy, the Fed's lone tool is a brake. If the coasting car is climbing a hill, and the Fed applies the break, the car is easily stopped, and gravity will reverse its direction. That is the situation the US economy is in now. We are trying to climb out of a deep hole dug back in 2008. The economy is very fragile, growth is relatively weak, unemployment is relatively high, excess capacity both here and globally is relatively high and if anything we risk tipping into deflation and recession than experience inflation. Given that context, if the Fed increased interest rates now, and set the price floor above the equilibrium rate, the economy would almost certainly be pushed back into recession. Ironically, that wouldn't even be good for gold. In reality the holders of gold, often the Fed's loudest critics, benefit the most from its policy. This truly is a case where gold investors had better be careful what they wish for - they just might get it.

The flip side of going up a hill is going down a hill. There is an inflection point, beyond which the rules change. Just like in the Pixar movie Cars where Lightning McQueen is told "to go left you have to turn right." Another more historical example is that Christopher Columbus believed the best path to the East was to sail West. Past the inflection point is where the Fed is really effective. Applying a break can't help get the car up the hill, but it sure can prevent the car from speeding uncontrollably down a hill. The Fed is best known for "taking the punch bowl away from the party." The Fed is the guest that pisses in the pool and spoils the party, and they are very very good at that. That is why inflation should be the last of investor's concerns. If there is anything the Fed knows how to do, it is stop inflation, so in my opinion, expecting the very entity that is known for its inflation fighting prowess to be the one that creates inflation is highly unlikely. Fighting inflation is easy, all they do is apply the breaks. When the car starts picking up too much speed and the kids in the back seat are yelling for more more more, faster faster faster, the adult in the driver seat puts on the break to slow things down and keep everyone safe. The kids may not like having the uncontrolled bull run down the hill slowed to a manageable speed, but it is the best thing to do. If the speed (inflation) gets too high, the breaks may overheat trying to slow the car, and the costs and damage created by stopping the car suddenly greatly increase.

The third misunderstanding is that monetary policy is why our economy isn't recovering. In reality it was monetary policy that prevented another Great Depression scale financial, banking and economic system collapse. There were zero bank runs and zero insured deposits lost among any FDIC insured Federal Reserve member banks. That is a huge success that people just seem to ignore, or fail to understand its importance. The problem America faces isn't our monetary policy, it is the tremendous uncertainty being created in Washington by the ever changing fiscal and regulatory policies. Changing healthcare, banking, carbon, energy, tax and spending policies combining with countless scandals puts a freeze on hiring, expanding and consumer spending.

The forth misunderstanding is that Fed created inflation is bad. The reason the Fed always errors to the side of slight inflation is because once again, they know how to slow a car rolling down a hill. The Fed knows how to fight inflation if it ever develops. The Fed has no power to push a car up a hill, which is what has to be done to fight deflation. The Fed can only push on a string, and because of that, if the economy stalls into a deflationary spiral like it did in the Great Depression, there isn't a whole lot the Fed can do to stop the fall. Panicked and terrified people simply will hoard their money under mattresses and in mason jars buried in the back yard. Dollars chasing goods and services drive the economy. If those dollars are taken out of circulation, transactions and commerce stop.

The fifth is that the Fed manipulates the CPI by removing food and energy to make themselves look better. That is pure nonsense and not just because the Bureau of Labor calculates the CPI, outside the control of the Fed. Food and energy are removed from the CPI to give a "core" rate because food and energy are highly volatile, and their price swings aren't usually driven by monetary policy. There is nothing the Fed can do to end a drought or prevent a flood or change ethanol policy. There is nothing the Fed can do to prevent China and other growing nations from driving up the price of oil. Those increases are natural market driven events, and altering monetary policy wouldn't change anything, in fact it would most likely make things worse. Fighting bubbles and the high price of gold also isn't the responsibility of the Fed. Just because the price of gold or a bitcoin is going parabolic, the Fed shouldn't slow the entire economy because of a few areas that are getting out of balance. The markets usually handle them through natural processes. Bubbles, food and energy prices are micro issues, whereas the Fed monetary policy is a macro tool that has to take the entire global economy into consideration.

In conclusion, the critics of the Fed are 100% wrong, and they have been wrong since 2008. The very fact that inflation is essentially non-existent, we had zero bank runs, we had zero insured deposits lost and the economy is slowly limping back to recovery in spite of insane fiscal policy and the resulting crippling uncertainty created in Washington proves that the Fed has been a phenomenal success. The markets are simply adhering to an understanding of monetary policy that is inappropriate for the current context. It is almost unthinkable that the Fed would allow interest rates to increase during a period when the economy is coasting uphill. The Fed is almost certain to allow the economy to make it up the hill and start coasting down the other side before they ever even think of putting on the breaks. To use another analogy, the wedding is just in the planning stage, and the punch bowl that will eventually have to be taken away hasn't even been ordered.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.