The Fed Is Between A Bubble And A Hard Place

Includes: DIA, JNK, QQQ, SPY, TLT
by: James A. Kostohryz

The Fed has made its bed; now it must lay in it.

For over almost five years, the Fed has engaged in an experimental policy of quantitative monetary easing that has been unprecedented in scale. Now, the Fed is faced with the daunting task of engineering a climb-down of the US financial system and economy from atop the dizzying heights of a towering mountain of excess liquidity.

This is not going to be easy, at all.

On the one hand, the real economy is still exhibiting extraordinary weakness, and the Fed risks derailing the tepid recovery if the withdrawal of monetary accommodation were to destabilize financial conditions and asset prices.

On the other hand, many Fed officials are cognizant of the risk of repeating the policy errors of 2003-2007. This was a period in which the Fed, which was at that time also dealing with a relatively lackluster and "jobless" economic recovery, perpetuated too much monetary accommodation for too long. The failure of the Fed at that time to withdraw excess liquidity from the financial system in a timely manner resulted in the formation of asset bubbles and relative price distortions that ultimately devastated the financial system and economy at large.

Thus, as the Fed lies in the bed that it has made, it finds itself between a bubble and a hard place. On one side of the bed lies the risk of asset bubble formation, which I have described in two articles entitled, "Why A Stock Market Bubble is Forming Right Now," and "Beware Of Long-Term Damage From Stock Market Bubble Forming Right Now." On the other side of the bed lies the risk of triggering another recession at a time when unemployment is already extremely high.

How is the Fed going to deal with this challenge? Elsewhere, I have described what the Fed is trying to do as "Jedi mind tricks." The Fed hopes that by confidently uttering things that are both suggestive and a bit mysterious, it can keep bond vigilantes bamboozled and stock bulls from running wild, while at the same time continuing to pump liquidity into the financial system to support the real economy.

Specifically, Fed officials seem to hope that mere suggestions about tapering, combined with confident bragging about the Fed's ability swiftly to withdraw (or accelerate) accommodation rapidly if conditions warrant, will be sufficient to persuade investors not to significantly bid down the price of fixed income assets such as TLT or JNK or to excessively bid up the price of stocks such as SPY, QQQ and DIA, despite increasingly clear evidence that excess liquidity is igniting inflation in certain select sectors of financial asset markets and consumer product markets.

Can the Fed pull off this very dangerous escape act? There are historical precedents to suggest it might, and there are precedents that suggest that it might not. Market reaction to this Wednesday's Fed announcements will provide important clues as to whether the Fed is on the right track in terms of pulling this off. For subscribers to my newsletter, on Wednesday afternoon I will provide an exclusive analysis of the Fed statement, the market reaction to it, and what all of this means for the future of financial markets, the economy, and your investments.

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.