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Thursday, April 03, 2008 12:07 AM


Fed Uncertainty Principle


Most think the Fed follows market expectations. Count me in that group as well. However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn't the market to blame if the Fed is simply following market expectations?

This is a very interesting theoretical question. While it's true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.

For example: If market participants are expecting the Fed to cut on weakness and the Fed does, market participants gets into a psychology of expecting more cuts on more weakness. Here is another example: If market participants expect the Fed to cut rates when economic stress occurs, they will takes positions based on those expectations. These expectation cycles can be self reinforcing.

The Observer Affects The Observed


The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg's Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

To measure the position and velocity of any particle, you would first shine a light on it, then detect the reflection. On a macroscopic scale, the effect of photons on an object is insignificant. Unfortunately, on subatomic scales, the photons that hit the subatomic particle will cause it to move significantly, so although the position has been measured accurately, the velocity of the particle will have been altered. By learning the position, you have rendered any information you previously had on the velocity useless. In other words, the observer affects the observed.

The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.

The Fed cannot change the primary trend in interest rates. However, the Fed can exaggerate the trend, temporarily slow it, or hold the trend for an unreasonably long period of time after the market (without Fed distractions) would have acted. This leads to various distortions, primarily in the direction of the existing trend.

A good example of this is the 1% Fed Funds Rate in 2003-2004. It is highly doubtful the market on its own accord would have reduced interest rates to 1% or held them there for long if it did.

What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.

In a free market it would be highly unlikely to get a yield curve that is as steep as the one in 2003 or as steep as it was just weeks ago when short term treasuries traded down to .21%. In other words we would not be in this mess without the Fed, or if we were, the mess would at least be smaller than the one we are in.

Would the market on its own accord be setting rates at the current Fed Funds Rate of 2.25? It's possible, but there is no way to tell.

It's even possible the Fed is behind the curve by not acting fast enough. This is of course all guesswork. I don't know, you don't know, and the Fed does not know what to do. This is part of the "Fed Uncertainty Principle" and a key reason why the Fed should be abolished. After all, how can you give such power to a group of fools that have clearly proven they have no idea what they are doing?

The Fed has so distorted the economic picture by its very existence that it is fatally flawed logic to suggest the Fed is simply following the market therefore the market is to blame. There would not be a Fed in a free market, and by implication there would be no observer/participant feedback loop.

The Fed hints at "possibility" of recession. We are already in one.

Today's headline reads Bernanke Nods at Possibility of a Recession.

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.
My Comment: Bernanke is passing the buck. If housing continues to collapse Bernanke will attempt to blame Congress rather that point the finger at the number one culprit in this mess: The Fed, for micromanaging interest rates and blowing bigger bubble after bigger bubble.
Mr. Bernanke, testifying before the Joint Economic Committee on Capitol Hill, said the economic situation had weakened since the Fed last reported at the end of January but that it could revive later in 2008 because of the $150 billion spending and tax cut package enacted this year.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”
My Comment: Bernanke clearly does not understand what is happening, or if he does, he is not telling the truth about it.

Uncertainty Principle Corollary Number One: The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

According to America's Research Group "Seventy percent of consumers who have received their 2007 income tax refund are using it to pay off credit cards and bills, the first time in 20 years that figure has topped 50 percent." See March Auto Roundup And Retail Sales Forecast for more on this topic.

Think you are going to get stimulus out of Bush's stimulus plan? Think again.
In separate comments, Mr. Bernanke went further than he had in the past, suggesting that the Fed would remain aggressive and vigilant to prevent a repetition of a collapse like that of Bear Stearns, though he said he saw no such problems on the horizon.
My Comment: Supposedly the Fed could not see the possibility of a derivatives chain reaction coming until after it started, even though this has been openly discussed in the news media for years.

Please see Who's Holding The Bag? and scroll down to the section "Warren Buffett vs. Greenspan" for a clear warning about derivatives.
By the end of his comments, it was also clear that he and the Fed were not entirely pleased with the “blueprint” for regulatory changes issued on Monday by the Treasury secretary, Henry M. Paulson Jr.

That proposal called for an overhaul and consolidation of the financial regulatory system. The Fed chief, in an almost classic case of damning with faint praise, said Mr. Paulson’s blueprint was “a very interesting and useful first step” for Congress to consider.
My Comment: The Fed is angling for still more power. This is a very dangerous situation.

Uncertainty Principle Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.
Mr. Bernanke, making his first public comments about Bear Stearns, spent a considerable amount of time defending the Fed’s actions in arranging for Bear Stearns to be acquired by JPMorgan Chase at a fire-sale price, and with the help of a $30 billion loan from the Fed.

Providing new details about the deal, which was arranged behind closed doors during the weekend of March 15, Mr. Bernanke said he and his colleagues at the Fed did not know until March 13 that Bear Stearns faced bankruptcy and that they quickly realized a failure to act would create a global crisis.
My Comment: It's clear the Fed acted illegally. I will have more on this below.
“With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence,” he said. “The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’s thousands of counterparties and perhaps companies with similar businesses.”
My Comment: Clearly the Fed learned nothing from the collapse of Long Term Capital Management (LTCM) to have allowed banks like JPMorgan (JPM) take on trillions of dollars worth of derivative positions.

Uncertainty Principle Corollary Number Three: Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Caroline Baum Blasts Fed Decisions

Caroline Baum hit one out of the park with her assessment of how the Fed handled the Bear Stearns problem. Please consider Fed Should Clarify Link to Bear Stearns Assets.
Watching the evolution of Fed policy in the last six months from focused on inflation to fearful of systemic risk; the series of aggressive, rapid-fire rate cuts; the creation of an alphabet soup of new lending facilities [TAF, TSLF, PDCF]; and the orchestration of a fire sale of Bear Stearns to JPMorgan, one has to wonder about the Fed's M.O. It all has a make-it-up-as-you-go-along quality.

Faced with what it thought would be a series of cascading financial failures if Bear Stearns went down, the Fed probably knew what it wanted to do, knew it had to do it quickly, and then had to figure out "how to get it done within the confines of its legal structure," DeRosa [a partner at Mt. Lucas Management Co.] said. "The Fed used legal sleight of hand to reconcile what they wanted to do with what they're permitted to do by law."

Bernanke is sure to be grilled about his actions when he testifies before the Joint Economic Committee of Congress today and the Senate Banking Committee tomorrow. A wee bit more transparency would be nice.

Then again, if the Fed is acting first and finding legal cover later, there's a benefit to keeping the details murky.
Fed's Actions Blatantly Illegal

John Hussman has this to say in his weekly column Why is Bear Stearns Trading at $6 Instead of $2?
The Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns' mortgage debt. But the bank – J.P. Morgan – was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.”

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the "collateral" would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.
Not only was the action illegal, the vote itself was illegal. The Fed needs 5 members to vote on such actions and only 4 members were present. Fed Governor Mishkin was missing in action. Was he opposed to this illegal hijacking? There was an excellent discussion of this idea in the comments section of the California Housing Forecast.

This leads us to....
Uncertainty Principle Corollary Number Four: The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Let's Recap.

Fed Uncertainty Principle:
The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed's actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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