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U.S. Economy: FED Manipulation, or How We Got Over the Edge – Paul Tolmachev

As we know, one of the main tasks of the FED in conducting monetary policy is the formation of expectations, what Thomas Schelling called “conditional behavior. Expectations determine the economic – and in general the social – behavior of economic agents, and thus economic dynamics and its direction.

An important goal of FED monetary policy is inflation targeting. This is one type of expectation formation and management, i.e., creating the conditions for achieving that very target “conditional behavior.”

Is it a good thing? On the whole, no. Of course, it is better than direct monetary intervention, and modern mainstream economics considers it a market-based way of conducting monetary policy through stimulus that excludes direct affecting. However, free-market advocates would say to this that appetite grows with food, especially when it comes to government regulation.

By continually increasing the leverage of the national economy in unbridled political greed, the government and the FED are somehow forced to expand and intensify their interventions in market mechanisms, since the crises produced by periodic imbalances resulting from state expansion can only be cured by even greater expansion. Otherwise, a self-imposed market bailout will be very painful for society as a whole and for economic agents, which, of course, is fraught with social and political turmoil.

The FED needs to put a good face on a bad game. It must still show independence from the executive branch and follow the natural course of indirect stimulation of economic activity and control of inflationary processes. But the formation of expectations and incentives, as “market” tools of monetary policy, in reality mutated into an extremely dangerous manipulation.

These manipulations are dangerous, among other things, because they result from the regulator’s false understanding of the nature of the market and its ability to account for all the factors affecting economic activity, the compilation options of these multiple factors and their transformations. This delusion is based, mostly, on little-factor economic models, the whole essence of which is reduced to averaging and the search of regularities through historical correlations. Time has repeatedly shown that such arrogance can end badly, and a little-factor modeling with unified averages is very tentative in its usefulness. A prime example of this that I often cite is the vertical Friedman vs Phillips curve. However, all paternalistic-Keynesian concepts based on linear relationships, which tend to be false, or effective only in a short horizon.

What kind of FED manipulation are we talking about here? Specifically, the manipulation of investor expectations. In fact, everything the FED has been doing lately has been deliberately and purposefully misleading investors. And it has nothing to do with shaping expectations. Rather, it has to do with the use of insider information and market manipulation, and even more likely, veiled government redistribution.

Anyone who has listened to the statements of the Open Market Committee, where monetary policy is developed, should have noticed the FED’s suspicious inconsistency in its treatment of inflation over the past two years.

First, two years ago, the FED claimed the transitivity of rising inflation and cited its main causes: the compensatory growth of post-consolidation demand and supply chain discontinuities. The FED argued that the problem was temporary and transient; no tightening of monetary policy was imminent. 

Investors naturally saw this as a signal for total buying: money is worthless, and the yield on risk-free assets is extremely low. This, of course, caused markets in all asset classes to rise extraordinarily.

Asset prices have dramatically detached from estimates of fundamental value. Nevertheless, the markets rose further, but it must be understood that no other scenario could physically be possible. In an environment where “everything depends on Joe” (a phrase from the movie Meet Joe Black), market incentives are subordinate to regulatory incentives. We all remember the mantra carrying a menacing message from the government: never play against FED.

At the same time, it is hard to imagine that the functionaries of the FED were not aware that the main cause of inflation was expanded to the cosmic limits of the state leverage. Even left-wing Keynesians, including, for example, Paul Krugman, spoke of the dangers of this unprecedented expansion of the money supply. Nevertheless, the FED has spoken, leaving no choice even to those portfolio managers who would like to stay out of such a price bacchanalia.

As I mentioned earlier, the rally affected all asset classes. Bitcoin hit 70,000, “brand-name stocks” were off every conceivable reasonable level of fundamental valuation on expanding buybacks and retail investor hyperactivity, real estate prices, with zero rates again hitting new peaks, naturally depressing low-income agents. It was reminiscent of a party with a large “supply for getting high” until morning…

However, the morning came, the “supplies” ran out and the inevitable aftertaste came: inflation began to skyrocket, agents’ expectations worsened, and those very “temporary problems” in the form of bottlenecks in production chains, as well as labor shortages and a sharp tightening of the labor market with rising wages – did not go anywhere.

Inflation in stores and gas stations has reached levels not seen in the U.S. since the late 1970s. What had been obvious to everyone from the beginning – eventually happened.  Then – not before! – The FED announced the need for monetary tightening: raising rates, cutting redemptions, and then easing the balance sheet altogether. The gates closed and almost everyone found themselves in a fenced-in corral – asset prices became totally inadequate to the rising cost of money, and sell-offs began. In fact, the FED forced investors to close the positions it had itself forced open.

In such a situation, when political greed, amidst a post-shaky recovery, has caused a major inflationary wave and brought the economy to the brink of recession (and technically the recession has already arrived), the FED, at the conclusion of the last Jackson Hole meeting, decided to declare that economic agents should “bear with us a little,” because inflationary risks are more dangerous than recessionary risks! It’s hard to argue with that, because a recession, albeit severe, would only clean up bloated government leverage in the real sector, while galloping inflation could have far worse economic and social consequences.

In particular, we should understand that market assets are the stuffing of portfolios of ETFs, pension funds, insurance companies and banks, i.e. all major aggregators of savings in the economy. High inflation will naturally eat up all the yield and lead to a depreciation of assets in these “purses,” and this is a huge social and political risk. So in this sense, markets are more important to the government than stagnation in the real sector and the sagging incomes of households.

The only problem is that both of the risks the FED is talking about were created by the FED and the government themselves!  This is a blatant example of living “one day at a time” where government and regulator decisions are populist and dictated solely by political objectives in the interest of the ruling bureaucracy, regardless of the obvious side effects that inevitably follow such decisions. Obviously, these externalities are supposed to be cured or neutralized by another state distribution: monetary stimulation, an increase in the tax burden and the expansion of state programs. The recently signed Inflation Reduction Act is vivid proof of this.

All the FED did was force market participants to act in a certain way. Why do I say forcing, not stimulating? Because the right thing to do in a free market would be to be guided by market endogenous factors in the first place, not by the position of the regulator. It was the regulator’s position that became the main driver of investment decisions and a factor in shaping the price – the supply and demand ratio – of assets. This is a very significant distortion in the operation of market mechanisms. The actual name for this is socialist transformation.

The purpose and meaning of all these inconsistencies and, on the face of it, strange behavior of the FED is only one thing – the need to show short-term (and it could not be otherwise) economic growth in all possible ways. This was vital to maintaining the stability of government and gaining social electoral loyalty. So if there are no questions about the government, everything is clear with it (it is an executive bureaucracy, its incentives and goals in the form of maximizing its utility are transparent and even natural), then there are many questions about the FED.

The main one is as follows:

Why do the actions of an independent central bank, the purpose of which is price and economic stability, create exactly the opposite effect – expanding the volatility of economic cycles and economic opportunities of agents? And the answer, taking into account all of the above suggests itself: the state redistributive mandate swelling like yeast, logically reduces the value of a truly independent market regulator. Moreover, this “leftist” paradigm naturally implies a synergy of all regulatory institutions and government in directly modeling economic relations.

This has nothing to do with the real market.

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The Russian-born Paul Tolmachev is portfolio manager at BlackRock (London, UK) with more than $500 million in personally managed assets. He also is a visiting scholar at the Stanford Institute for Economic Policy Research, where he researches institutional and political economy, decision science and social behavior. Paul Tolmachev is a Certified Professional in Philosophy, Politics and Economics (PPE Program), Duke University. Having 20 years’ experience on the financial markets, Paul Tolmachev held management positions in leading Russian and international investment and wealth management firms. As a research scholar for the past few years, he has also specialized in the analysis of macroeconomics, politics, and social processes. Paul is a columnist and contributor to a number of international think tanks and publications, including Duke University, Mises Institute, Eurasia Review, Investing.com, etc.