Fed finally making policy for humans, not Vulcans: James Saft

September 10, 2013

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) – Someone at the Federal Reserve finally figured out that we are not Vulcans but humans.

Rather than pointy-eared aliens constantly performing discounted cash flow calculations, we are actually, as investors, often chumps, prone to irrational enthusiasms leading to bubbles, San Francisco Fed President John Williams acknowledged in a speech on Monday. (here)

The implication is that many of us are about to feel that very human emotion of chagrin as we watch the value of our houses and stocks go down.

That’s because, though it didn’t mention expectations that the Fed next week will begin to shave back bond purchases, the speech provided a very cogent explanation of why they very likely will.

And when they do, and when investors realize it is more about risk control than economic management, lots of assets will go down in price.

Williams laid out how subject to momentum investor expectations are, with people easily getting too optimistic or pessimistic. Rather than evaluating value, investors simply assume things will carry on as they have.

“Asset price bubbles and crashes are here to stay,” Williams said. “They appear to be a consequence of human nature.”

What’s worse, one bubble leads to another, just as the bubble in housing drove bubbles in everything from construction workers to home improvement stores.

“This recognition of the source of asset price movements means that work on monetary and macroprudential policies needs to refocus on how these policies may damp or amplify asset price cycles, rather than how they should respond to asset prices per se,” Williams said.

To translate – central bankers ought to be willing to change policy to head off or puncture bubbles.

Classic economic theory assumes that investors make rational decisions, which in turn has allowed central bankers to ignore bubbles because they aren’t part of their equations.

And lest you think this isn’t about what is happening right now, or what the Fed will do next week, Williams praised the sell-off in bonds which happened when Ben Bernanke in June said the Fed’s bond buying could come to an end later this year. That market move was evidence that there was an “emerging bubble” in bond markets and the fall in prices and rise in yields was healthy, he said.

To be sure, Williams is not a voter on the policy-setting Federal Open Market Committee this year, but he is a career Fed employee, has been a fairly reliable member of the Bernanke consensus and has been thought, if anything, to be something of a dove on monetary policy. When this kind of guy makes this kind of noise, you can expect that Fed policy will not be a straight reaction to economic data.


Which makes sense, because the data, while not a disaster, is not painting a picture of an economy about to boil over, at least if you consider the Fed’s supposed dual mandates of inflation and employment.

The employment report, released on Friday, was quite weak, with job growth in recent months revised strongly downward, and a mediocre 169,000 jobs created in August. And while the unemployment rate ticked down to 7.3 percent, that is more a function of declining labor force participation, itself a phenomenon driven by discouraged workers and poor opportunities.

The Fed has set guidance that indicates that it will keep rates just above zero so long as the unemployment rate remains above 6.5 percent and inflation stays contained.

There is no real worry on the inflation front either, with core inflation up just 1.7 percent in the past year.

There are, in fact, two bits of muddled thinking coming out of the Fed, which, given the high intelligence at work, perhaps tip its hand.

The first is the reliance on the unemployment rate, which measures all sorts of things like demographics and discouragement, and is not the keystone upon which to build one’s policy.

The second is the idea that cutting back on bond purchases, which are currently running at $85 billion per month, does not constitute tightening. Of course it does, as it makes monetary conditions that bit tougher if the Fed isn’t distributing $85 billion a month of electronic cash while racking up bonds.

Mortgage rates are higher and will probably go higher still if the Fed actually tapers, so unless, in opposition to Williams’ view, the bond market has it wrong, this is a tightening.

As such, it will be bad for risky assets. Just look at emerging markets.

But, as Williams explained very well on Monday, given that we are human and likely to do any number of foolish things, backing away from a policy which may cause bubbles seems a very good idea.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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