A Black Swan?

Nassim Taleb popularized the idea of Black Swan events in his best selling books, "Fooled By Randomness" and "The Black Swan". These events are unpredictable and have significant effects on financial markets. Market participants are adept at constructing narratives in hind sight that make the events seem obvious. The 2008 housing crisis which produced the worst economic downturn since the Great Depression of the 1930s along with a market crash is an excellent recent example.

The key is that the event be totally unexpected. It can be either good or bad.

One candidate I believe that is out there at present is that the actions followed by Central Banks and the U.S. Federal Reserve will actually produce a well functioning global and U.S. economy. This is based on my watching the markets, reading about the markets and talking to investors. I have to say that I don't know of anyone who thinks that there aren't some serious bumps and bruises if not much worse in the near to intermediate future coming from following a zero interest rate  and negative interest rate policy. I have to add that I believe this is so even for the Fed governors in their heart of hearts. Uncharted waters are scary

But, what if the economy ratchets up its growth rate to 3%, the unemployment rate drifts a bit lower in the U.S., tax collections reduce the deficit and the Federal Reserve has the Fed Funds rate at a more  normal 3% rate say in 4 years? Wouldn't this qualify as a "Black Swan"?

And surely all those now predicting a sharp downturn immediately ahead would have no problem creating a narrative explaining how we got on the road to nirvana.

To be absolutely clear I don't expect this to happen. This is merely an academic exercise to keep us on our toes. To be sure, I'm in the camp of those who believe that manipulating the price of money or practically the price of anything is bad policy and distorts the system (i.e. creates bubbles) and eventually ends badly.

What the Fed Doesn't Get

For some reason, the Federal Reserve still believes that tightly controlling the most important price in the economy - the price of money -  over the long term is the way to meet their long-term objectives of 2% inflation and full employment.  Their policies penalize struggling retirees living off of fixed income and favor the big banks who are subsidized with low-cost reserves.

Controlling prices goes against history and especially recent history. It will land Yellen and, yes, Bernake right in the penalty box with Greenspan.  It will be crowded in there because most Fed governors as well as Fed Bank presidents will be in there as well.  Recall Greenspan's history.  He was dubbed the "maestro" for his rate-manipulating prowess--until that very prowess set off the bubbles in the dot.com sector and then housing that resulted in the worst economic downturn since the 1930s and brought the economy to the brink of another Great Depression.

The history is not complicated.  All you need is a chart of the Fed Funds rate:

Source: Economagic

This is the rate targeted by the Federal Reserve as explicitly specified in the statement released at the conclusion of each Federal Open Market Committee (FOMC) meeting.  The rate target is anxiously awaited by the investment community at the conclusion of each meeting, and its changes are predicted and stressed over in the financial press.  If you need an immediate assessment, just check out the circus at CNBC up to and following an FOMC meeting.

Today, and for some time, as shown on the graph, the rate is essentially zero and is expected to stay there for a "considerable time."

All the various interest rates in the economy  are correlated--which means that, by controlling the Fed Funds rate, the FOMC affects your monthly car loan, how much interest retirees receive on certificates of deposit ( a pittance), and even monthly mortgage payments.  It affects the value of the dollar in global trade.  Controlling the general price of money isn't akin to controlling the price of ice cream.

It doesn't take much reflection to realize that investors love that the Fed spells out in excruciating detail its thinking of how it is going to control the rate - especially when the Fed is either lowering or holding it low for a prolonged period of time.

But history shows controlling interest rates isn't all good.  First look at 2003 on the graph above.  For a 12-month period, the rate was brought down to 1% and held there for 12 months.  Why?  An important reason was the bursting of the dot.com bubble in early 2000.  But why the bubble?  Where did it come from?  This isn't rocket science.  Most market observers get this part.  From 1987 on, Greenspan stepped in every time the financial markets faltered and lowered the Fed Funds rate, leading to the coining of the phrase "Greenspan put."  It reached a point where investors threw concerns about risk to the wind and even piled into newly issued securities of companies that had only vague business plans and no clear path to profits.

Why?  Hey why not - the Greenspan Fed was the golden goose that would rescue markets.

Econ 101 teaches that controlling prices builds pressures over time.  Historically, this has been seen whenever wages and prices were controlled.  So, here we are today with a long trailing period of time where the Fed--in its wisdom--held the price of money below where normal market forces would push it.  And the pressures have built.  Capital will flow or not flow depending on market views of when the price will change.  Look back at the graph and notice the change following 2003 whereby the rate was pushed to 5.25%!  Capital flowed into housing with mortgage rates at historical lows and then was abruptly cut off!  Jobs were easily and widely available in residential construction, mortgage banking, etc., and then they weren't.

The way off this bubble-creating, capital mis-allocating merry-go-ground is straight forward.  Just target the growth rate of the money supply.  For example, M2 growth could be targeted at 3%, say.  This would then enable the price of money, i.e. interest rates, to be set by the market, as most prices in a free market economy are set.