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Thursday June 30, 2005 - 11:33:03 GMT
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Spin the wheel on the final outcome


“The measure of success is not whether you have a tough problem to deal with, but whether it’s the same problem you had last year.”

John Foster Dulles
FX Trading

“It is quite possible that the Fed may decide to push the fed funds rate higher in order for liquidity growth momentum to start trending down. By doing this the Fed will set in motion a depressing effect on economic activity some time in the future—more than likely in 12 months or so time. In the meantime the lagged effect of the tighter interest since June 2004 is likely to start to undermine various activities that sprang-up on the back of past loose liquidity thereby setting in motion an economic bust,” writes Frank Shostak, adjunct scholar of the Mises Institute.

I think Mr. Shostak’s straight forward and lucid description of “why the conundrum” is a good one. And explains why a decision on where to stop raising rates is critical for economic growth and difficult to assess. A couple of interesting charts from Mr. Shostak’s piece appearing on the Mises Institute website:


The chart above shows that despite the increase in Fed Funds rate, the Fed was still pumping credit into the economy. Mr. Shostak is basically saying here: Conundrum solved!

And here is another interesting chart showing the percentage change in industrial production vs. the Fed Funds rate. It provides some validation to Mr. Shostak’s view of a 12-month lag between changes in the funds rate and when it starts to show in the real economy.


Mr. Shostak’s explanation shows us why Mr. Greenspan is at least in a quandary even if he has figured out the “conundrum.” In other words, if Fed Fund hikes are starting to bite now, how much more tightening makes sense going forward? Where is the elusive point of “interest rate normalization”? If the Fed pulls back on the reins now, does that set off a whole new leg up in the speculative party layering more froth on top of froth?

It’s no wonder Mr. Greenspan speaks in such measured phrases. He is smart enough to understand that no matter where he looks, it seems possible to develop competing theories to support whatever path he chooses. And given the complexity of our economy—one based on the irrational action of living humans, and thus lacking the structure of measurable supply and demand curves that appear in our textbooks—Mr. G’s tools for evaluation of the impact on the economy from monetary policy past is also quite limited.

Where is this so-called equilibrium in the economy? In a dynamic economy, with fluctuating prices, there is no such thing. There is a tendency toward equilibrium—or subjective evaluations of that point, but no such thing is achieved—otherwise prices would stop fluctuating. And an economy without fluctuating prices i.e. a pricing system, is an economy that is dead. The Soviets tried to override fluctuating prices.

Is there a point here? Well maybe. The point I am trying to make is #1: We can’t forecast interest rates because the people in charge of manufacturing interest rates can’t do it either. And #2: We need to focus not on the theory, which can help us understand in retrospect, but on expectations.

“If the process of adjustment does not lead to equilibrium, what happens to the conclusions of economic theory? The answer is that they remain valid as deductions but they lose their relevance to the real world. If we want to understand the real world, we must divert our gaze from a hypothetical final outcome and concentrate our attention on the process of change that we can observe all around us,” write George Soros.

So, we may be able to guess the final outcome today from the Fed. But the key will be guessing the real world reaction as reality plays out against consensus expectations. Now that’s a conundrum that will be with us for a long time to come.

Jack Crooks
Black Swan Capital


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