What If the Fed Has Lost Control?

When this bubble bursts, there will be no fourth or fifth bubble, there will only be rubble.

The US economy and its financial system operate under the implicit belief that the Federal Reserve controls the direction of the economy and finance. This belief isn’t in Fed influence, it’s in Fed control: the Fed can reverse a stock market decline on a dime, it can reverse a recession, it can do “whatever it takes” to keep markets stable and expansive.

The history of the past 30 years seems to support this belief. Every time a financial crisis has manifested, the Fed has “saved the day” with some new policy extreme, changing the rules, jacking up its balance sheet 10-fold, and so on.

The flaw in this confidence in Fed control is the three speculative bubbles that have inflated and burst in the era of Fed Control, 1995 to the present. These bubbles could not have inflated without a “dovish” Fed pushing interest rates down and juicing the financial system with liquidity / credit. Since all speculative bubbles eventually burst, the Fed is forced into “rescue mode” which requires ever more extreme manipulation, oops, I mean intervention, to stabilize the bubble bursting and inflate the next bubble.

What few entertain as a possibility is the Fed is losing control of the economy and finance for systemic reasons that have nothing to do with Fed Policy per se. In other words, it’s not a “Fed policy error” that brings the system down, it’s much larger forces: diminishing returns and second order effects.

The immediate effect of new Fed policy extremes is strong, much like a new drug has an immediate effect. But as the drug is injected again and again, it loses its efficacy. In medicine this is a biological process; in finance, it’s a psychological process as participants habituate to every new Fed policy extreme and count on its 1) permanence and 2) continued efficacy.

For example, the Fed’s trick of lowering bond yields / interest rates. Participants can confidently increase their exposure to risk to insane levels and dispense with hedges because they’re confident the Fed will drop interest rates back to zero if the stock market falters.

This confidence in the efficacy of Fed policies can be understood as a buffer, providing resilience and a backstop (“the Fed Put”) to any financial / economic instability. Participants stop panicking the moment the Fed announces a new dovish policy, even if the policy has limited effect on real-world conditions. The decline of real-world efficacy is masked by the instant euphoria of participants, who have come to count on the Fed’a actions resolving crises literally overnight.

The decay of diminishing returns occurs under the radar. Few understand all the Fed’s actions (reverse repos, etc.) or the scale of these operations, or their efficacy in terms of correcting dis-equilibrium / instabilities in the real-world economy and markets.

While participants continue to believe these buffers will always protect the system from hazard, the buffers have eroded. The next Fed “save” fails, revealing the buffers have collapsed. Put another way, the Fed has lost control.

Every new Fed policy extreme generates second order effects which unleash unintended consequences. The prime example is moral hazard, the belief that risk can be taken on to boost speculative gains without suffering any consequences of that risk blowing up.

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