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The Fed is not the Reason You’ve Been Wrong

There’s no doubt that Central Banks wield enormous power, but I sometimes get the impression that people think Central Banks are omnipotent.  We hear this often about QE and how the Fed has manipulated asset prices higher.  The implication here is that the Fed has artificially boosted asset prices as though there is no underlying fundamental reason for asset prices to be where they are.  The most common arguments around this assertion generally involve charting the Fed’s balance sheet next to the stock market (see here for instance) or declaring that interest rates would be dramatically higher if the Fed weren’t involved in the markets.  But both of these assertions are misleading.

We know that stock prices have rallied in tandem with record high corporate profits.  I’ve talked about this tirelessly over the years and there’s a real fundamental driver of profits given that you’ve understood the Kalecki equation and been able to connect all the dots.  It’s simply wrong to claim that stock prices have no underlying fundamental driver.  Would they be lower if the Fed wasn’t involved in the markets so aggressively?  Probably.  But we can’t know that.  What we do know is that stock prices are reaching record highs at the same time corporate profits are at record highs and that actually makes a lot of sense.

On interest rates – well, we also know that inflation has been extremely low.  The Fed is trying to create inflation, not deflation.  So the fact that interest rates keep falling along with the rate of inflation is quite a conundrum for the Fed.  They can’t seem to push inflation up.  In fact, some economists are now debating if QE is deflationary.  So, would interest rates be higher if the Fed weren’t involved in the markets?  Perhaps.  But they could also be even lower if one considers that a counterfactual world might have resulted in a truly deflationary period in which interest rates would have been that much lower.  So again, interest rates are low for reasons that are clearly outside of the Fed’s control.  That is, interest rates are low because inflation is low and the Fed can’t seem to do anything to get inflation higher.  Therefore, I think it’s safe to assume that interest rates would be low and perhaps even lower if the Fed weren’t so involved.

The strange thing is that I tend to keep seeing the same arguments from the same people who keep getting huge macro calls wrong.  For instance, we’ve seen an endless stream of negative commentary from hedge fund manager Paul Singer in recent weeks about how the Fed is manipulating everything.  But it turns out that Singer has been wrong on big macro calls like interest rates because he simply misinterpreted what QE would do.  He thought it would bring a ravaging inflation with it which would drive interest rates higher.  But it didn’t do that and interest rates fell along with the rate of inflation.  So Singer’s bet against T-bonds ended up being wrong.  But he wasn’t wrong because of the Fed.  He was wrong because he misunderstood the efficacy of QE to cause inflation.  Many of us have been saying for years that QE wouldn’t cause sky high inflation.  So it’s not like this was a totally unpredictable result.  But some people seem to want to blame their misunderstandings of the monetary world on an easy scapegoat.  And the Fed is certainly an easy target there….