Wednesday, September 02, 2015

Irrational Credibility

Interpreting economic events these days is complex to say the least.

Back in the “housing bubble” days (when this blog was originally launched) the story was much simpler… housing was overvalued resulting in an economy that was far too leveraged (dangerously so) to the housing sector and to the irrational belief in the continuation of its exceptional expansion.

It only took a consensus agreement of this fact (in clear contradiction to the prevailing “contained” story promulgated by the Fed) for the wheels to finally come off the cart.

The “tech-boom” of the 90s had a similarly concise story… the enthusiasm for tech stocks got way out of hand (understandably considering the notable technological improvements of the internet and telecommunications in general) and led to price-to-earnings multiples that were clearly irrational.

But today, the irrational exuberance is not over one specific sector or asset class, it concerns a concept with much less tangible and understandable dynamics… it’s over the credibility of Fed itself.

Let’s face it, the “Greenspan Put” model of the Fed, whereby the Fed extends an “easing” hand to the markets every time there is a potentially systemic shock (i.e. Crash of 87, LTCM, post-tech wreck 1% FF rate), took a hideous turn for the worse in the wake of the housing collapse resulting in a string of unprecedented interventions that any rational observer could see would be difficult to reverse or, in the Feds parlance, “normalize”.

The belief that the Fed can, in fact, successfully “normalize” and the associated underlying anxiety that they might NOT be able to bears a strong resemblance to the physiological tug-of-war that was present during the prior housing and tech booms whereby most participants (households, firms, investors) continued to play along even though there was at least some degree, even if very diminished and subconscious, of understanding that circumstances could be out-of-line and that a reversal was possible.

So, in a sense, the ability for the Fed to successfully earn back its credibility by creating room for its traditional policy tool (the Fed Funds rate) and thereby reestablishing some semblance of normalcy is tantamount, conceptually, to housing actually “never going down” or to the tech stock boom actually ushering in the “end of the business cycle”.

That is, it is the best case scenario… the one that avoids the ugly reveal of the truly awry circumstances we all inherently know, even subconsciously, to exist.

That’s not to say that the Fed can’t succeed… but the key here is to acknowledge how high the stakes truly are… this is a pivotal moment to say the least.

If the Fed blinks in September as a result of the recent stock market turmoil and leaves the Fed Funds rate at the zero-bound, that could work (more that any other prior event) towards tipping the collective psychology one major step in the direction of loss in confidence of the Fed.

Also, recent speculation that declining stocks is equivalent to Fed tightening thereby giving the Fed some cover for inaction in the September meeting misses the point entirely.

The Feds ability to build more room in their primary “normal” policy tool has NOTHING to do with the Fed Funds rate’s text-book function and all to do with proving to the world that the Fed is credible and, more importantly, that their ability to “normalize” is truly rational.