So here’s what I read when I woke up this morning:
The dollar has been hit by expectations the Fed will announce new stimulus measures next month, diluting the dollar’s value.
But it gained strength Wednesday after a report in the Wall Street Journal suggested the Fed could take a more gradual approach to the stimulus and after an upbeat report on U.S. consumer confidence.
NEW YORK (AP) — Stocks slid Wednesday as concerns grew over whether the Federal Reserve’s plans to buy Treasury bonds might be smaller and slower than anticipated.
And here’s what I wrote a month ago:
Here is a recent story from Yahoo.com:
“NEW YORK (Reuters) – Stocks rose on Tuesday after opening lower on weak economic data, with investors saying the data bolsters expectations the Fed will pump more money into the economy, which would support equities.”
And what sort of economic data was weak?
“September data showed U.S. consumer confidence fell to its lowest level since February, underscoring lingering worries about the strength of the economic recovery, while home prices dipped in July.”
Let’s suppose consumers react with a lag to economic data, or suppose the survey was done early in the month. In that case the survey might have reflected the very weak economic data coming out in August (revised GDP at 1.6%, etc) and also a weak stock market, which was partly a response to the weak data.
So let me get this straight:
1. The markets were weak in August, causing a low consumer confidence number in September
2. This leads investors to expect more easing by the Fed
3. This leads to a stronger stock market
4. This will lead to a better consumer confidence number in October
5. Which will lead investors to fear the Fed won’t ease
6. Which will cause stock prices to fall in October
7. Which will lead to a weaker consumer confidence number in November.
8. And so on
Are you getting dizzy yet? This is the so-called “circularity problem,” which occurs when the Fed tries to target market expectations. It was discussed in 1997 in a pair of JMCB papers by Garrison and White, and also Bernanke and Woodford.
The Fed needs to be careful here. It’s easy to say the Fed doesn’t respond to the stock market; but let’s face it, they do. They cut rates after the 1987 crash, even though there was no sign of recession or deflation, and they announced a bond purchase program in March 2009, right after a sickening plunge in equity prices. Make all the jokes about the stock market you want, people do see it as an important indicator of which way the economy is headed. Even if only subconsciously.
So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise. Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008. Using Wall Street lingo, they could “fall behind the curve.”
I guess markets aren’t efficient after all. My blog is “public information” and any investors who bought S&P puts right before the Fed response to the consumer confidence number could have made a killing. I think I’ll take TheMoneyIllusion.com private, and start charging a fee.
Seriously, this has all happened before. Here’s how I described the events of late 1933:
The distinction between flexible (commodity) prices and a sticky overall price level is crucial to any understanding of Roosevelt’s policy. For instance, when Roosevelt decided to formally devalue the dollar in January 1934 [and stop the gradual depreciation], many prominent economists such as E.W. Kemmerer predicted runaway inflation. Prices did rise modestly, but remained well below pre-depression levels throughout the 1930s. Pearson, Myers, and Gans quote Warren’s notes to the effect that when the summer of 1934 arrived without substantial increases in commodity prices:
“The President (a) wanted more inflation and (b) assumed or had been led to believe that there was a long lag in the effect of depreciation. He did not understand–as many others did not then and do not now–the principle that commodity prices respond immediately to changes in the price of gold”. (1957, p. 5664.)
Warren understood that commodity prices in late January 1934 had already incorporated the anticipated impact of the devaluation, and that commodity price indices were signaling that a gold price of $35/oz. was not nearly sufficient to produce the desired reflation.
One of the most important monetary economics papers of the 20th century was published in 1957 in Farm Economics. I wonder how many famous economists have even heard of it.
PS. Please, no angry comments; I was just kidding about predicting the market and going private. Does anyone really think I’d ever abandon the EMH?
PPS. I’m going to a conference in Dallas tomorrow (on Karl Brunner.) Depending on whether the hotel has a computer, the blog may slow down for a few days. But I’ll be blogging furiously on November 3rd–you can count on that.