Friday, June 21, 2013

Don't F**k With The Prices

In The Road to Serfdom, Friedrich Hayek wrote: 

Any attempt to control prices or quantities of particular commodities deprives competition of its power of bringing about an effective co-ordination of individual efforts, because price changes then cease to register all the relevant changes in circumstances and no longer provide a reliable guide for the individual's actions.

First and foremost, Hayek was a Classical economist, but I am going to try to channel his philosophy on Price Controls, to ponder the work of a Monetarist Fed.

I'll be the first to admit that only monetary policy could have cleaned up the mess monetary policy created. It took about five years starting in 2001 for the housing market to ramp up in valuations to bubble status with the help of the Fed, and about two years to devastate the world economy despite the efforts of the Fed.

Five years into the recovery, I think it’s time to pull the morphine drip.

The first step on the road to normalization is acceptance. The smart folks at the Federal Reserve need to internalize the idea that somewhere mixed up in all the chaos of a global financial crisis, we might have experienced a structural shift in the labor markets, with regards to the natural rate of unemployment.

At this point, I think it’s safe to say that the scope of the (monetary induced) financial crisis has been exceeded. It’s time to let the economy be an economy again. Following Heyak’s logic, the Fed makes a habit of fixing the price of money, and has been exceptionally active as of recent with the Quantitative Easing programs.

As a result of being the buyer of last resort for so long, the Fed has unofficially taken on the role of chief underwriter of the US equity markets. Participants don’t seem to want to transact unless it’s with the Fed’s money. Added to that, a recent annual report by the Financial Stability Oversight Council warned that “a sudden spike in yields and volatilities could trigger a disorderly adjustment, and potentially create outsized risk.” From my vantage point, this seems to put the decision makers at the Fed in a bit of a pickle. Their presence in the market is the sole source of confidence and liquidity that has been keeping yields and volatilities low. The same low yields that make government and household borrowing costs lower and low volatilities that make investors feel wealthier and more inclined to further invest have been supporting the economic recovery.

Extreme monetary price fixing was needed, for a time, but that time is past. In short, there’s no obvious way to avoid the withdrawal that is going to result. We have to expect higher yields and higher volatilities. The question is, how much of the shock can Fed dissipate around market participants, and how are they going to do it?