The Federal Reserve Fighting Market Forces

Every year, in late August, financial regulators, academic and private industry economists, and the like gather in Jackson Hole, Wyoming, for a talkfest. This year, Fed Chairman Ben Bernanke will speak on Friday (Aug. 27), and will probably announce more quantitative easing. That would mean further efforts to lower medium and long term interest rates (the Fed has already lowered short term rates to zero). What, technically speaking, the Fed will do remains to be seen. But the goal is to prevent deflation.

Policy makers tell us to shrink from the horrors of deflation. Consumers, we are told, will stop buying in anticipation of lower prices. Holders of capital will stop investing, hoping for better deals later. Home values will sag, discouraging consumption all the more. The nation will sink into another Great Depression.

One problem: that describes current conditions. People have cut back on consumption. Holders of capital (at least individuals who tend to be long term investors) are fleeing the stock market. Real estate prices are stagnant or falling in most of the country. We're not in another Great Depression. But we already have deflationary behavior.

Another problem: deflationary behavior makes sense. With unemployment high and not falling in a meaningful way, it's rational to spend less and save more. People have relearned the age-old lesson that debt is undesirable, and they're deleveraging. Private industry is hoarding cash, as are the big banks, to have a fallback in case the economy fades again. There are still so many bad home loans outstanding, and so many foreclosed houses, that real estate prices can't rise significantly, not for years to come.

The prosperity from the early 1980s to 2008 was built on an ever expanding cushion of credit. Credit spurred home values to rise, allowed consumers to raise their living standards even as their incomes stagnated, and puffed up stock and other asset prices. Credit became the cure for all problems economic. That is, until it was used well beyond the limit of its logic and the credit bubble burst. Deleveraging set in, and still continues. Asset values are falling--as they should in a time of deleveraging. Consumers are cutting back, which is a logical consequence of deleveraging. Our current stagnation is understandable. It's just the result of market forces in operation.

The Fed is trying to fight the market. It's printing money to keep asset values inflated. It's bought a ton of mortgage-backed assets in order to support real estate values. It's essentially given the big banks a big subsidy so the banks can continue to support, through lending, market making and trading operations, the values of all kinds of asset classes.

Any experienced Wall Street trader knows you can't fight the market. The market always wins in the end. Deflation may not be pretty, but it's a natural result of the bursting of a credit bubble. Deflation pushes prices down, but at some point consumers see bargains they can't pass up. Investors see stock values they genuinely find attractive. When home prices fall far enough, plenty of buyers will qualify for loans even with today's stringent credit standards. Demand will revive, as will the economy.

By substituting monetary policy for market forces, the Fed is creating an artifice, where people hold back because they know current prices aren't right. They fear that buying now means losses tomorrow. The more the Fed delays the operation of the market, the longer people hold back. Eventually, they may permanently embrace parsimony. In the capital markets, no one wants to invest long term because they can't believe current prices are solid. Individual investors head for the hills, while professional investors clog up the markets with low risk, high speed trading and other short term speculation financed with the Fed's bargain basement interest rates. No one is embracing risk. Everyone's running from it. On a certain level, the Fed's interventions create deflationary behavior.

The mother of all quantitative eases has been taking place in Japan, and it hasn't worked. Japan's stock and real estate markets have deflated, while its structural unemployment has risen. Japan isn't in a Great Depression. But it can't pull itself out of the quagmire. Market forces were blocked from normal operation in Japan, and now Japan's economy doesn't function well.

America isn't Japan, but market forces are the same worldwide. The Fed can't suppress the market forces pushing America toward deflation. Maybe it can mask their impact to some degree. But the Fed's relentless printing of money is bound to distort markets, asset values and capital allocation. Deflation isn't pretty, and for the unemployed, it's a Depression. But deflationary behavior today is rational, and the Fed wants people to act contrary to their sensibilities. If the Fed doesn't allow market forces to operate, what exactly is supposed to happen? What's the substitute game plan? Does anyone really know?