Fed President Defends Blowing Bubbles: It's In The Best Interest Of "Irrational Investors"

Tyler Durden's picture

It would appear the Fed, after being angry at itself for creating the "complacency" evident in the markets globally has reached the pinnacle of critically circular logic in its defense of policies that are aimed at financial stability (i.e. prices flat or rising but absolutely not falling). Fed's Williams, a la Greenspan's "a-ha" moment, appears to have realized that investors are not always 'rational' and "bull markets may cause investors to get ‘carried away’ over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices."

The "carried-away"-ness then leads to crashes which the Fed must then re-inflate to ensure financial stability... but because "it remains difficult to know when markets have gone wrong," or as a rational, normal person would say, when the "rational" Fed has blown yet another bubble, Williams does what any other self-respecting career economist would do: calling for additional study into the matter.

Via The Wall Street Journal,

The Fed realizes investors do not act rationally... blowing up their models entirely...

“In a world of rational expectations, asset prices adjust and that’s it,” Mr. Williams said. ” He added, “but if one allows for limited information, the resulting bull market may cause investors to get ‘carried away’ over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices.”

 

Mr. Williams explained that it appears to be the case that investors, on balance, look at where a given market has been heading and assume that pattern will persist. Rapidly rising markets fuel the belief the good times are here to stay, while market blowouts generate such pessimism that investors cease to act as if prices will rise again.

 

“The recognition that people behave in this way can move us a long way closer to understanding how asset price booms and busts can emerge and how policy actions could influence that process,” he said.

And then there is Philly Fed's Plosser - who suggests in fact that instead of "managing" this irrationality and tamping it down, the Fed should encourage it just a little longer...

Economists would say that policymakers are trying to commit to a policy that is not time-consistent.

 

Put another way, former Fed Chairman William McChesney Martin used to say that monetary policy’s job “is to take away the punch bowl just when the party is getting good.”

 

Yet, these models tell us that at the zero lower bound, forward guidance should convey the opposite. That is, it should promise that monetary policy will not remove the punch bowl but allow the party to continue until very late in the evening to ensure that everyone has a good time.

 

But what will make the public believe that policymakers in the future will deviate from past practices in this way?

Even as several Fed member are expressing grave concerns about the instability and complacency already embedded in investors irrational expectations...

In comments after a speech last month, New York Fed President William Dudley observed “volatility in the markets is unusually low.” He said “that makes me a little nervous because I’ve got to believe that even though most people in the room have something close to my view of the economy, there’s always the possibility of big surprises.”

 

In a speech this week, Kansas City Fed leader Esther George, long a critic of the Fed aggressively easy money policy stance, again lamented actions taken by the central bank may be promoting too much risk taking, of a sort that could eventually come to woe.

But Williams says, The Fed can't see bubbles anyway...

Mr. Williams flagged that it remains difficult to know when markets have gone wrong, and he called for additional study into the matter.

So in summary... It's entirely circular...

The Fed must blow bubbles because otherwise irrational investors get "carried away" and inevitably crash the markets...

Ultimately it seems clearer and clearer that, as Williams himself opines "financial stability is just as important as pursuing price stability and growth."

But Ben Bernanke said their actions were for Main Street, not Wall Street?

Ultimately it is clear that The Fed wants supreme control to protect us all from irrational investors...