The Fed's Reflexive Catch 22 In One Sentence

A month ago, we explained that the key issue complicating the Fed's taper in particular, and exit policy in general, is that the Fed is now caught in a "reflexive" corner, where the mere hint of tightening (because Bernanke just admitted tapering is just that) pushes markets so far and so fast, that the Fed has no choice but to delay or outright cancel said tightening, in the process losing further institutional credibility. And so on, until eventually the inflationary spiral takes hold, at which point it will be too late to respond proactively, and then the Fed pulls a 2008 and complains bitterly how "nobody could have seen the asset bubble coming" and so on. For anyone still confused by this Catch 22, here it is summarized by Deutsche Bank's Jim Reid:

Another theme arising from their decision to hold fire was their worry that financial conditions had tightened over the past few weeks. If this is the case then the path of tapering is going to be tough because every time the market thinks they are going to taper, yields will likely rise and conditions will tighten. However the Fed's guidance is becoming confused enough now that you couldn't rule out another change of emphasis, especially as the composition of the Fed will change notably over the next few months. So markets are underpinned by liquidity for now but it’s a fluid situation and it strikes me that the Fed do not have a clear direction at the moment which makes them difficult to second guess.

And since the economy is made worse by the Fed's constant intervention in this positive feedback loop, what is obvious is that the Fed will never step away, until such time as it has soaked up so many securities and so much liquidity from the markets, that even the final policy vehicles, the bond and stock markets, grind to a halt. The good thing is that it is now abundantly clear that no news, no headlines, no wars, frankly nothing beside the Fed's balance sheet matters.


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