Fed Inaction Is Creating An "Infinity Paradox"

Posted by Bigtrends on September 25, 2015 8:05 AM

Deutsche Bank Explains The Fed's Decision By Mixing Quantum Theory With Post-Modernism

by Tyler Durden

Bored of cut and dry (and 100% spot on) explanations of why the Fed did not do a "hawkish hold" or a "dovish hike" just because Goldman's Jan Hatzius told Bill Dudley not to order a lobster sandwich at the Pound and Pence? Then you are in for a treat...

From Deutsche Bank:

September FOMC meeting felt like a blind date that was never meant to be. As the market developments were unfolding, Fed members simply didn’t like what they saw. Despite seemingly robust US data, the global economy appears too fragile and the strong USD is in the center of the crisis. The developments in EM have been negative for risk and, if conditions deteriorate further, the net result could be in a nontrivial adverse impact on DM economies. Rate hikes and further USD strength could have made things considerably worse. So, while the market waited, Fed decided not to engage.

 

Going into the FOMC meeting, we had to face multiple nested contingencies, from Fed reaction function, to ambiguous signals given by the economic models which largely underwent structural breaks post-2008 and eroded market’s already low confidence regarding economic forecasts. The Fed decision showed that when everything fails, common sense remains the best guide. And common sense prevailed. 

 

This changes everything. 

 

Power relations have been revealed; nothing will ever be the same. In that sense, despite seeming status quo, the FOMC was a true Event in the sense of being an encounter which retroactively creates its own causes.

 

What we now have is another data point which outlines the contours of the Fed reaction function. Fed’s communication strategy, it is becoming clear, is an equivalent of what in theater context is referred to as Removing the fourth wall whereby the actors address the audience to disrupt the stage illusion -- they can no longer have the illusion of being unseen. An unalterable spectator becomes an alterable observer who is able to alter. The eyes are no longer on the finish, but on the course -- what audience is watching is not necessarily an inevitable self-contained narrative. The market is now observing itself from another angle as an observer of the observer of the observers. 

Got that? No? That's ok.

This is Deutsche Bank channeling their inner Diderot on the way to mixing Schrodinger's uncertainty principle with the greatest hits of Jacques Lacan and Jacques Derrida all in a rather amusingly metaphysical attempt to explain that the market must now account for itself when attempting to predict the actions (or inactions) of a body (the Fed) that impacts it. 

In other words, it's no longer enough to for investors to consider what effect the Fed will have on the market - now, investors must come to terms with the fact that the market affects the Fed which affects the market. 

Or, stripped of all the self-referential confusion: The Fed has admitted that it is market dependent and investors must somehow come to terms with their own role in the play.

Presenting The "QE Infinity Paradox", Or "The Emperor Is Naked, Long Live The Emperor"

Perhaps the most important thing to understand about what was widely billed as the most important FOMC decision in recent history, is that by “removing the fourth wall” (to quote Deutsche Bank), the Fed effectively reinforced the reflexive relationship between its decisions, economic outcomes, and financial market conditions.

In simpler terms, differentiating between cause and effect is now more difficult than ever as Fed policy affects markets which in turn affect Fed policy and so on. 

This sets the stage for any number of absurdly self-referential outcomes.

For instance, the Fed needs to remain on hold to guard against the possibility that a soaring dollar triggers an EM meltdown that would then feed back into developed markets, forcing the FOMC to reverse itself. But delaying liftoff sends a downbeat message about the state of the US economy which triggers the selling of domestic risk assets. Hiking would solve this as it would signal the Fed's confidence in the outlook for the US economy, but that would be USD-positive which is bad news for EM. 

A similarly absurd circular dilemma presents itself if we take the view that the Fed missed its window to hike and is now creating more nervousness and uncertainty with each meeting that passes without liftoff. Here’s how former Treasury economist Bryan Carter put it to Bloomberg: "short-end rates move higher as the Fed gets closer to hiking, and that causes the dollar to strengthen, and that causes global funding stresses. They are creating the conditions that are causing the external environment to be weak, and then they say they can’t hike because of those same conditions that they have created."

When you tie the reflexivity problem in with the fact that the excessive use of counter-cyclical policy is leading to the creation of ever larger asset bubbles by effectively short circuiting the market's natural ability to purge speculative excess and correct the misallocation of capital, what you get is a never-ending loop whereby the consequences of unconventional monetary policy serve as the excuse for doubling and tripling down on those same policies. 

It's with all of the above in mind that we present the following flow chart from RBS' Alberto Gallo who illustrates the "QE infinity paradox":

QEInfinityParadoxBig

Courtesy of zerohedge.com

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