The Fed Has Painted Itself in a Corner

Published on naked capitalism, by Yves Smith, May 24, 2013.

Bernanke managed to shoot global markets in the head the day before yesterday, and then, as has become typical when investors throw brickbats at what the Fed has said, various mouthpieces go about talking the markets back up … //

… So despite the Fed starting to try to prepare Mr. Market for an eventual end of QE, the factors above strongly suggest, as critics fear, that the central bank will tighten late. But that won’t necessarily be because they’ve read the data wrong. In fact, Fedwatcher Tim Duy’s latest article if anything suggests that the Fed is suffering from a bad case of confirmation bias. Since it needs to believe its policies are working, it is motivated to see a recovery in the data. Plus its need to promote the confidence fairy also biases its perception (studies have shown that lawyers who defend a client that they suspect is guilty often come to believe in his innocence by virtue of having to sell his case). Duy believes that the central back will back out the effects of “fiscal drag,” aka deficit cutting, from its assessment of growth, yet appears not to be allowing for how much worse unemployment is than the headline statistics thanks to the exclusion of discouraged workers (and that’s before we get to underemployment). The Fed thus seems to have a predisposition to read data releases in a self-flattering manner. That would tend to favor an early exit from QE.

However, the market upset it triggered should give some pause. It may believe it has successfully contained any damage; the Japanese market, which had a wild ride, with the Nikkei down 3.3.% in the afternoon, still ended the day modestly higher (although that had more to do with Kuroda than the Fed’s ministrations). But stock valuations in the US are looking frothy in the face of declining earnings, which increases their vulnerability to shock. So if mere talk of ending QE produces this sort of reaction, the Fed is likely to hesitate to end it, even if it does have a bias to optimism in its data readings.

The one reason this might not be as terrible as it sounds is that with labor markets slack, it’s harder to generate real economy inflation than you think. But the longer the Fed carries on with its poorly-designed QE, the more fear-inducing its end will be.
(full text).

Links:

Gretchen Morgenson on Bill Moyers, The Case for 4% Inflation, on naked capitalism, by Yves Smith, May 26, 2013;

Video: Why Too Big to Fail Still Lives, 18.38 min, on naked capitalism, May 25, 2013.

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