Caroline Baum has an interesting discussion of feedback loops and Fed policy on October 19 in Bernanke Frets Over Sherlock Holmes’s Next Stop.

Federal Reserve policy makers like to explain the world in terms of feedback loops, except those of their own making.

Last year, a negative feedback loop threatened to deepen the financial crisis as a weak economy and a teetering banking system led to layoffs and production cutbacks, which led to even bigger declines in output and employment.

Last month, officials heralded the onset of a “positive feedback loop,” wherein better financial conditions and stronger growth in employment and output lead to a stronger stock market and improved financial conditions, according to minutes from the Fed’s Sept. 22-23 meeting.

At some point, of course, the loop gets broken. Otherwise, the economy would head in one direction, up or down, forever.

Where is the discussion of the Fed’s inflation expectations feedback loop, which yields no feedback and less information?

Expectations Loop-de-Loop

If I have this right, we’re waiting for the Fed to do or say something to help us decide whether we should hoard cash (because we expect the dollar to buy more tomorrow if prices are falling) or buy and hoard hard goods (if we expect inflation to diminish the dollar’s purchasing power).

The Fed, in turn, is waiting for us to do something so it can decide what to do: either raise the volume on its anti- inflation rhetoric with talk of exit strategies and price stability; or talk softly to allay fears of premature rate increases to keep market rates from rising.

If I read the minutes and other Fed communications correctly, policy makers are relying on us to tell them what to do, we’re relying on them for direction, and we’re locked in this no-way-out feedback loop that provides no useful information for either party.

To say that you and I have the ability to create inflation on our own flies in the face of monetary theory. If we did have a set of keys to the printing press, the Fed would have more than just inflation expectations to funnel through its feedback loop.

Fed Uncertainty Principle

Caroline asks: “Where is the discussion of the Fed’s inflation expectations feedback loop, which yields no feedback and less information?

The answer is right here, in the Fed Uncertainty Principle, written April 3, 2008.

Most think the Fed follows market expectations. Count me in that group as well. However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?

This is a very interesting theoretical question. While it’s true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.

For example: If market participants are expecting the Fed to cut on weakness and the Fed does, market participants gets into a psychology of expecting more cuts on more weakness. Here is another example: If market participants expect the Fed to cut rates when economic stress occurs, they will takes positions based on those expectations. These expectation cycles can be self reinforcing.

The Observer Affects The Observed

The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

To measure the position and velocity of any particle, you would first shine a light on it, then detect the reflection. On a macroscopic scale, the effect of photons on an object is insignificant. Unfortunately, on subatomic scales, the photons that hit the subatomic particle will cause it to move significantly, so although the position has been measured accurately, the velocity of the particle will have been altered. By learning the position, you have rendered any information you previously had on the velocity useless. In other words, the observer affects the observed.

The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.

What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.

Would the market on its own accord be setting rates at the current Fed Funds Rate of 2.25? It’s possible, but there is no way to tell.

It’s even possible the Fed is behind the curve by not acting fast enough. This is of course all guesswork. I don’t know, you don’t know, and the Fed does not know what to do. This is part of the “Fed Uncertainty Principle” and a key reason why the Fed should be abolished. After all, how can you give such power to a group of fools that have clearly proven they have no idea what they are doing?

The Fed has so distorted the economic picture by its very existence that it is fatally flawed logic to suggest the Fed is simply following the market therefore the market is to blame. There would not be a Fed in a free market, and by implication there would be no observer/participant feedback loop.

Fed Uncertainty Principle:
The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Where The Hell Is The Outrage?

I added a few more points to Where The Hell Is The Outrage? to take care of the above issues. Here they are:

I am outraged at a Fed that purports to be “inflation fighters” when the only source of inflation in the word are central bankers, and their fractional reserve lending policies.

I am outraged that Greenspan and Bernanke could not see a housing bubble that 1000 bloggers could see.

I am outraged at the selective memory of Bernanke when speaking to Congress about these problems.

I am outraged that Bernanke’s one sided response to asset bubbles, letting them grow without end, then bailing out the financial institutions that cause them.

I am outraged the Fed exists at all. It is a useless organization that cannot see bubbles, that panders to banks, that supports inflationary policies that are tantamount to theft by fraud.

Mike “Mish” Shedlock
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