The Broken Links In The Fed's Chain Of Cause & Effect

Tyler Durden's picture

Excerpted from John Hussman's Weekly Market Comment,

The Federal Reserve’s prevailing view of the world seems to be that a) QE lowers interest rates, b) lower interest rates stimulate jobs and economic activity, c) the only risk from QE will be at the point when unemployment is low enough to trigger inflation, and d) the Fed can safely encourage years of yield-seeking speculation – of the same sort that produced the worst economic collapse since the Depression – on the belief that this time is different. From the foregoing discussion, it should be clear that this chain of cause and effect is a very mixed bag of fact and fiction.

To be fair, we do believe that some components of the Fed’s thinking are well-supported by economic evidence. For example, in her presentation at Jackson Hole, Fed Chair Janet Yellen observed that real wage inflation remains low, and that this is an indication of ongoing slack in the labor market that isn’t well-captured by the rate of unemployment. On this point, we would completely agree. To the extent that the true Phillips Curve (which relates unemployment to real wage inflation) describes reality, it’s sensible to assert that low real wage inflation informs us that the unemployment rate has not declined to a level that reflects labor market scarcity – though we should also recognize that real wage growth would already be much higher if there was not such an extreme gap between real wage growth and productivity growth.

Where we differ from Chair Yellen is in a variety of supposed cause-effect relationships that aren’t supported by evidence to any meaningful extent, and in the neglect of systemic risks that are undeniable if one has been paying any attention at all to the macroeconomy over the past 15 years.

Let’s trace some of the links in the chain of cause and effect.

First it’s clear that increasing the monetary base relative to nominal GDP will predictably and reliably lower short-term interest rates. This is true at least until the point that, as has occurred across history and across countries, inflation picks up rather uncontrollably – often following a supply shock coupled with government deficit spending – with very little at all to do with the prevailing unemployment rate. In any event, nearly a century of data provides very clear evidence of a tight link between monetary base/nominal GDP and the level of short-term interest rates.


The next link in the chain is the assumption that suppressed short-term interest rates are somehow good for economic growth and job creation. Here, the cause-and-effect link is much weaker. It’s certainly true that suppressed short-term interest rates result in yield-seeking and the enhanced availability of loans to low-quality borrowers who offer higher yields than are available on safe alternatives. But it’s also clear that QE does not do much to stimulate real investment, where there are numerous costs and risks beyond the cost of money (and where hundreds of billions of idle dollars are available on corporate balance sheets even in the absence of further QE). Rather, QE primarily encourages speculation, leveraged finance, and other forms of financial “engineering” where interest represents the primary expense. The objective of these activities is not job creation, but leveraging the “spread” between the return on one financial asset and the interest that one must pay to acquire it with borrowed money.


On Yellen’s inflation views, the argument that general price inflation will only follow real wage inflation is really an argument that general price inflation will only follow low unemployment. At best, this view is half right. There’s good evidence that low unemployment tends to result in higher real wage inflation (the real Phillips Curve), but it does not follow that real wage inflation is naturally associated with faster general price inflation. Indeed, because general prices are the denominator of real wages, faster general price inflation tends to reduce real wages in the absence of a spiral in all nominal prices where wages take the lead. That’s just arithmetic. Aside from some short-term cyclical pressures, we’re not terribly concerned about rapid inflation at present, but we also don’t find much evidence that unemployment, whether at current levels or lower levels, is the central factor that would determine inflation anyway.


The most dangerous assumption of the Fed is that the primary risk of QE is inflation, and that QE is somehow a benign policy in the absence of inflation risk. Yes, we would love to see lower unemployment, and agree that stronger growth in real wages would likely result from that. It’s just that the transmission mechanism from QE and zero-interest rate speculation to lower unemployment is either nonexistent or so poorly defined that the policy can only be considered reckless. The Phillips Curve dogma of the Fed has created blinders that narrow its view of risk to some abstract “tradeoff” between inflation and unemployment. Meanwhile, the speculative tenor of the markets is contributing to a very real risk of steep financial disruptions, not only because risk-assets are overvalued, but because debt is increasingly being purchased on the basis of yield rather than the careful evaluation of repayment prospects.

In short, the greatest risk of QE is not the inflation risk that may or may not emerge, but the financial distortion, overvaluation, and speculation that is already baked in the cake and is progressively worsening, in a manner quite similar to the 2000 and 2007 extremes, though less evident because the cyclical elevation of profit margins makes prices seem tolerable relative to current earnings. As I’ve frequently noted, based on equity valuation measures that are most reliably correlated with actual subsequent stock market returns, stocks are now more than double their pre-bubble historical norms, and presently suggest that the S&P 500 will be no higher a decade from now than it is today. We expect the current QE bubble to unwind no more kindly than the prior bubbles in 2000 and 2007. See Ockham's Razor and the Market Cycle and Yes, This is An Equity Bubble for additional background on these concerns.

As for the U.S. economy, conditions aren’t bad overall, but the benefits of economic activity are highly uneven. 40% of families report that they are “just getting by,” with the majority essentially living paycheck to paycheck without enough savings to cover even a few months of expenses. We could be, and should be doing better, except that this complex adaptive system of ours responds to good incentives as well as bad ones, and has been repeatedly crippled by policies that have produced waves of malinvestment, bubble, and collapse. The economy is starting to take on features of a winner-take-all monoculture that encourages and subsidizes too-big-to-fail banks and large-scale financial speculation at the expense of productive real investment and small-to-medium size enterprises. These are outcomes that our policy makers at the Fed have single-handedly chosen for us in the well-meaning belief that the economy is helped by extraordinary financial distortions. The Federal Reserve is right to wind down quantitative easing, and would best terminate reinvestment of maturing holdings, ideally beginning in October or quickly thereafter. The issue is not whether the U.S. economy does or does not need “life support.” The issue is that QE is not life support in the first place.

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buzzsaw99's picture

the fed believes this, the fed assumes that... how naive.

Newsboy's picture

The overdue reset will be even worse, but is inevitable.

The lies to kick-the-can are understandible.

TeethVillage88s's picture

FED has Plausible Deniability in taking the Position that Economic Policy, Domestic Policy, Employment Policy is Set by US Congress who are our Elected Representatives.

However we can create a list of "Defacto" FED Policies:

1) Globalism is in auditable, so "Slavery" & Indentured Servitude is Defacto FED Policy
2) Open Borders Deflates US Wages as does Foreign Worker Visas, and is Defacto encouragement of creation of "Slavery" & Indentured Servitude in the USA
3) Organized Crime is behind much "Slavery" in the world, FED Defacto Supports Organized Crime by not speaking out
4) Drug Prohibition creates Crime Lords, Arms Sales, Black Market Petroleum Sales, Money Laundering, and clearly a huge Waste of Federal Fiat Dollars spent in the "War on Drugs", FED is Defacto supporting Flawed Federal Policies and Wasteful Federal Budget Inflation by not Speaking out
5) War on Middle Class, War on Fixed Income People, War on Disabled & Elderly as Health Care Inflation reflects a Cruelty not seen before in world history, Defacto FED war on Fixed Income, Middle Class, & Poor creating indentured servants
6) Over 90 Million people in USA are not working, FED says nothing and pretends it is only 8 Million people, Defacto FED policy to create debt & poor people that will work for the lowest wages

Question: Who does FED Represent & is this the reason for Antisemitism's Rise in London, Europe & USA???

Conclusion: Isn't Fascism what you get with a Military Republic that starts wars for resources, supports Dictators & Tyrants in order to promote Weapons Sales & Economic Allies, Engages in Covert Operations to overturn Democratically Elected Governments & Latin America, Supports Rampant Wall Street Fraud & Bribery of Congress even in the Event of Global Financial Crisis & Stealing US Pension Funds, and Formation of Police State.

tempo's picture

churches pray that the God will stop the evil isil. God gave us bombs to stop isil. Pray that Obama will use them for good. Love your neighbor means that a Christian cares enough for his neighbor's children when they are being killed to take meaningful military action, not just smile and offer them a warm cup of coffee when their children have been killed.

cpnscarlet's picture

If one H-Bomb has been dropped on 9/12/2001 by the US, even in an empty patch of barren land in Iran, Iraq, or Afghanistan...

The last 13 years would have been much more peaceful.

Or if the US announced on that day that the Dome of the Rock or Mecca had been put on our targeting lists, we wouldn't be dealing with IS now.

The only thing these MFMuzzys understand is brute force served up wholesale. Like all other human beings, their leaders can talk all day about "embracing death", but would quickly change their tune if it's their own death they have to embrace.

OpenThePodBayDoorHAL's picture

Total misreading of reality. The end of the Cold War was a gigantic wake-up call for the legions of companies and politicians who make their living from war, looked like the gravy train was ending. They needed a brand new, permanent enemy, and guess what, they got it. Now anytime Permanent War looks like it's slowing down they can just pick a new country to blow up (Ukraine) or just switch sides (Syria). Perfect.

cpnscarlet's picture

I don't think you got the point of my argument. If we had dropped a bomb worth about $15M, or made a policy change that is effectively free-of-charge, we wouldn't have to have spent $1.5T in low-heat battles since 2001.

It's the tried-and-true concept that those not ready to fight a war always wind up in one.

I think of dropping an H-Bomb after 9-11 is like that scene in Dr. Strangelove - "Shoot it man! That's what the bullets are for!"

doctor10's picture

If there were ANY real businessmen part of the Fed-they would understand why capital is worthless in the USA today.


By the time its licensed, regulated, taxed, insured and is trying to dodge the torts emanating from the local shysters-its a lot easier for anybody with any creativity to go elsewhere.

q99x2's picture

Its hard making money when you are being robbed blind by the FED banksters.

Uber Vandal's picture

Looted is a better choice of words.

Along with sodomized.

cpnscarlet's picture

There is a basic error here.

Inflation is only hidden by misinformation. It is all too real. However, as the CPI is skewed, interest rates are suppressed by monetiziation, and gold is supressed by paper, inflation is only felt by those who have no voice, and, therefore, does not "exist". This ends when the fascades are lifted by our currency war enemies and the price of gold is set somewhere other than the COMEX and London.

Until then, pass the popcorn.


lotsoffun's picture

the hyperinflation is ALREADY here.  but - it's not in the same way as the past, bread and butter basics for the working class.

thanks to computers making it possible to 1 - print digital money and 2 - manage all that money flooding into assets - primarily one STOCKS.  stocks do NOT go up 15 - 20% every year for 5 years.

there is your hyperinflation.  and it IS different this time, because that is new.

cpnscarlet's picture

OK, so the fascade ends when the market crashes, since at these low volumes, only those selling at the margins will get the high prices for their stocks. Then, the bubble has to move somewhere else to keep the Ponzi going. I still think the final effect is gold going hyperbolic.

The fiat game always ends that way.

Your thoughts?

doctorZH's picture

I think you are right.  I have been predicting for many years, buy gold in 2001 and sell and shortsell gold in 2019.  Well, the Fed has been busy trying to saboutage gold during these middle years as an alternate currency.  But I believe we will have a rush at some point through 2019.  Hyperbolic.  Having said that, gold does not look good here, so I am assuming the FED is still shortselling naked Gold ETFS to keep people from becoming gold enthusiasts.

g speed's picture

because the "price of stocks go up" is not indicitive of inflation --Stock price is arbritray and not connected to any price discovery mechanisim ---- anymore---- just like pricey art. 


ebworthen's picture



a)  QE + 0.25% loans to banks at the Treasury back door allows banks to gamble while making loans to sheeple at 4.5%-29%.  This necessitates not paying savers so the banks can fuck everybody over a barrel.

b)  Lower interest rates enables gambling in the equity casino by said banks using dark pools of levered derivative turds funded by taxpayers while encouraging corporate stock buybacks and employee layoffs. 

c)  The risk from QE is punishing savers and rewarding crooks to the point where no one has one speck of faith in the system anymore to the point they all say "fuck it!", don't save a penny, lever to the hilt, and join the crook's game.

d)  The FED cannot safely encourage anything, and is recklessly encouraging debt based yield chasing speculation that will rob generations of savings and eventually the society of any capital base with which to rebuild from this ponzi house of cards.

Tall Tom's picture

d)  The FED cannot safely encourage anything, and is recklessly encouraging debt based yield chasing speculation that will rob generations of savings and eventually the society of any capital base with which to rebuild from this ponzi house of cards.



Well do you have Gold? Those with the Gold, at the end, will have the capital base with which to rebuild.


Gold Ownership is true savings.

Notsobadwlad's picture

Yes, gold will have some value. That is if you can find someone who needs or wants your gold.

For the average person a toothpick has more intrinsic value than gold. Now a golden toothpick, THERE we might have something!!

socalbeach's picture

On your point a), it's even worse than you make it sound.  The banks only borrow about $230 million from the Fed discount window, and the rate is 0.75%.  Instead they are using mostly customer deposits for loans and speculation.  I don't know about you but I'm only getting about 0.1% on my bank savings account (money market deposit account, not a money market fund), and 0.006% on my bank checking account balance.

TeethVillage88s's picture

Did you hear the one about the Protests in Jackson Hole representing 70 different Groups... and they asked for continued ZIRP or LIRP.

Well there is a Book called "Why nations Fail" which points out the Extraction of Economic Wealth is the biggest reason that Nations Fail today. Plus it points out there is no Incentives to Saving money, Starting Businesses, taking Care of Credit, or even securing pensions or retirement savings... or something like that.

Seems to me FED is a one trick pony. They don't represent many groups very well. Why NOT create higher interest rates for Individual Savings Accounts while having LIRP for Business Creation???

But look many sectors in the US Economy are inflating... while other sectors like consumption are deflating... and Real Value in Economic GDP is falling while "Rent Seeking" and Extraction of Wealth is Increasing.

Truth: FED no longer recognizes the Sector that wants increased consumption... It only supports Debt Creation, Increasing debt in Public sector, and Private sector and Households... and supports Rent Seeking and Wealth Extraction.

Or maybe I just Read it someplace.

Notsobadwlad's picture

Yes, the nation will fail before the banks fail (and already is. People have no confidence in the so called "leadership", believing them infinitely corrupt and incompetent, and have little hope for improvement in the future.) ... there is something wrong with that.

doctorZH's picture

It's a problem with the way we see the world.  Everything is eitehr this or that.  If Inflation is good, deflation must be bad.  Our incessant moralism and dualities keep us from seeing how the world works.  Clearly inflation is good when the econonmy grows (1911-1929; 1947-1965; 1983-2001) but inflation is not good when the economy STOPS GROWING (1929-1947; 1965-1983; 2001-2019).

Either-this-or-that needs to become Both-this-and-that.  We need to understand, as Goethe wrote, that everything is 'in stages'.  Our belief in the object implies a kind of moral stasis.  Once you understand the game you have to be on one side or the other.  But 'sides' are always changing, flowing into the other: mutating.

Summer growth is good; Winter deflation is also good, in season.  GROWTH IS NOT PERPETUAL.  Growth, any kind of growth, economic growth, natural growth, intellectual seasonal, and is always followed by rest, deflation, or sleep.  We need leadership that understands this.  We can't always be young and powerful and filled with life.  Sometimes we have to be old also.

Notsobadwlad's picture

Implying that increasing the monetary base will decrease interest rate gives the impression that there are market forces at work, which in fact, in this case, do not appear to exist. There is no competition for money and rates. The supply is essentially infinite and we depend on the banks to control themselves (A BIG JOKE, EH?)

Change the assumption to: "Monetary base size determination and interest rate determination are two independent events, both controlled by the Fed" (and collusively with its owner banks) and all of those market based assumptions that the idiots at the Fed are cramming down people's throats as gospel go completely out the window. You'd think they would know the difference ... and it is pretty certain that they do.

Can they control supply and rates forever? Well, that is the big question, isn't it? The people who are looking for some market based crash assume, "no", it will eventually get away from them. I think yes, at least for as long as they need to accomplish their larger goals... and what are those you might ask? I have my ideas, but rather than share mine right now, I think people should look at the actual effect of their actions and then assume that they are EXACTLY WHAT THEY WANTED THEM TO BE. They are not incompetent at all. They are just lying scumbags who have no interest in preserving the entire human species as their slaves.

socalbeach's picture

To be more precise, the claim is that increasing the monetary base (MB) per dollar of nominal GDP causes short-term interest rates to fall.  There is a mathematical derivation of this result which I haven't taken the time to study.  If you look at the first graph in this Hussman article on his website, an 85 year plot shows a tight relationship, and he says it "is one of the strongest relationships between economic variables you’re likely to observe in the real world."

Assuming the relationship still holds, one consequence is that if short-term interest rates rise, price inflation would become unacceptably high if the Fed doesn't reduce it's balance sheet. This would happen because the MB would be undesirable to hold, causing rapid turnover of base money (higher velocity of the MB). Or looking at the graph, if interest rates rise and the MB stays constant, nominal GDP must rise in order for the variables to stay on the scatter plot (interest rates rise, MB/GDP falls, since GDP increases).  The only way that can happen over the short term is through higher price inflation, since nominal_GDP = real_GDP * price_Level, and real GDP couldn't increase fast enough.

techstrategy's picture

"Inflation" will happen when currency rates are allowed to balance global flows or fiat breaks altogether. 

Spungo's picture

Does the fed actually believe inflation is caused by employment? Argentina must have had a really strong workforce in 1990.

socalbeach's picture

Dr Hussman seems to think the Fed believes in an inverse relationship between the unemployment rate and inflation ("Misguided Phillips Curve").  More likely the Fed just uses it as a cover for their goal of bailing out and enriching the financial system.

Hubbs's picture

From all the opinions I read, I think it boils down to what Paul Craig Roberts says in so many words....
It all starts to unwind when the rest of the world is finally fed up using the dollar as the reserve currency, and that from what I can gather, once one major currency like the dollar or euro or yen fails, the others will go quickly as well. The world will realize it's all confetti.
Once the dollar becomes confettized, The Fed will be irrelevant.

AdvancingTime's picture

We should understand that demand drives investment, confidence is not the real driver. Lack of real growth is about lack of real demand. Much of the demand we see today is driven by artificially low interest rates and QE that distorts the markets.

 We must differentiate the kinds of economic growth and understand that all growth is not created equal. If you spend money but afterwards have little to show for it you have wasted it. Sadly, much of the money America "invests in itself" each year through government spending and programs falls into this category. More on the kind of growth we need in the article below.

EndOfDayExit's picture

I keep reading Hussman every week for the last few years and am starting to wonder why he is always staying in the macro-economic realm and never touches on politics (while he does quote ZH occasionally, so he must be reading it). His macro analysis is most likely correct, but I doubt it fully explains what the Fed is doing and why it is doing it… And I don’t think Mr. Hussman is that naïve to not understand it. Does not want to spook investors with conspiracy?