The Fed's Jedi Mind Trick

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NEW YORK (TheStreet) -- The Fed understands that it must quickly wind down QE, lest the experiences of 2001 to 2007 be repeated. During this fateful period, the Fed maintained too much monetary accommodation for too long (2001-2003), and then failed to remove the excess liquidity from the economy in a timely fashion (2003-2007). The result was the formation of asset bubbles and relative price distortions, which ultimately led to devastation of the U.S. financial system and overall economy.

Still, cognizant of these risks, many Fed officials are also concerned that economic growth in the U.S. is very weak and vulnerable to reversal. These officials fear that removal of monetary accommodation could trigger instability in credit markets, which could in turn derail the weak recovery being experienced in the real economy.

What will the Fed do in the face of this dilemma? They have apparently decided that Jedi mind tricks are the answer. By confidently uttering things that are both suggestive and a bit mysterious, the Fed hopes that it can keep bond vigilantes bamboozled and stock bulls from running wild, while at the same time continuing to pump liquidity into the economy ostensibly to support the real economy.

Specifically, Fed officials hope that mere suggestions about tapering, combined with confident bragging about the Fed's ability to swiftly withdraw (or to accelerate) accommodation, if conditions warrant, will be sufficient to persuade investors not to bid down the price of fixed-income assets such as iShares Barclay's 20+ Year Treasury Bond and SPDR Barclay's High Yield Bond (thereby increasing their yields), despite growing signs that excess liquidity is igniting inflation in select sectors of asset and product markets.

To understand the magnitude of the Fed's challenge, you must first ponder the following graph, which illustrates the enormous level of excess liquidity that has accumulated in the U.S. financial system and economy.

During the early phases of the recovery from the 2008 financial crisis, this unprecedented level of liquidity pumped into the system by Fed policies did not pose a problem, and was indeed helpful to the economy, as long as the demand for liquidity (liquidity preference) was high. The current problem is that as risk aversion subsides and liquidity preference becomes more normal, the entirely abnormal liquidity balances sloshing around in bank and money market accounts have begun to be deployed by business and individuals.

Thus far, most of these deployments (and the attendant acceleration of monetary velocity) have been directed to the purchase of investment goods, causing the prices (and volumes) of assets as junk bonds and stocks represented in index ETFs such as SPDR S&P 500, PowerShares QQQ and SPDR Dow Jones Industrial Average to rise. By contrast, relatively little of the excess liquidity in the financial system has flowed into the real economy to stimulate the production of goods and services.

Going forward, the risk is two-fold. First, incipient asset inflation in certain assets such as junk-bonds, stocks and real estate can turn into a full-fledged speculative bubble as households and businesses with abnormally large cash balances rush not to miss out on the boom.

Second, the liquidity that does manage to find its way into the real economy will tend to flow into the most profitable sectors that are already hot and are in many cases already experiencing tightness in labor and product supply conditions. The consequence will be price rises in those sectors and dangerous relative price distortions in the real economy, as the prices of some goods and services rise sharply while the prices of other goods and services continue to fall or stagnate.

I believe that most Fed officials are aware of these problems and understand that it is imperative that QE not only be wound down but that liquidity be reined in. Nevertheless, the fact of the matter is that it is not the Fed's legal mandate to prevent asset bubbles and relative price distortions. The Fed's legal mandate, as established by Congress, is to promote full employment and overall price stability.

Please note that regarding the second mandate concerning price stability, the Fed defines it with reference to core CPI inflation, which is simply an average of many prices. Unfortunately, the Fed has never acknowledged relative price stability as part of its mandate, despite the fact that relative price distortions (caused by some prices rising rapidly while other prices fall, stagnate or rise less quickly) are far more damaging to the economy than across-the-board price inflation.

In sum, as long as core CPI inflation remains contained, and unemployment remains high, the Fed will err on the side of risking asset bubbles and relative price distortions for the sake of promoting full employment.

Having said this, Fed officials do not wish to admit explicitly that they are assuming this risk, as many of them understand how damaging asset bubbles and relative price distortions can be to the economy in the long run. This is where the Jedi mind tricks come in.

Conclusion:The Fed is going to tell us today that "tapering" is imminent, sending a suggestive but somewhat vague signal that the wind-down of QE has begun. This part of the message is meant to keep the bond vigilantes at bay.

At the same time, the Fed is going to say that monetary policy will remain accommodative for an extended period even after tapering has begun; QE will continue (albeit at a reduced pace) and short-term interest rates will be retained near zero. This part of the message is directed at investors concerned that growth could be derailed.

To all of this, the Fed will add a further dash of intrigue by confidently proclaiming that the Fed stands ready to reduce or increase the level of accommodation as conditions warrant (as if it were so easy for the Fed either to forecast conditions correctly or effectively to dial monetary accommodation up or down at will).

The Fed's strategy is this: Baffle the bond vigilantes with some mysterious and even contradictory suggestions that keep them guessing and paralyzed. At the same time, keep pouring in the liquidity and continue pretending there are no risks to this policy.

Folks, this is a mind trick, straight from the Jedi playbook. On Wednesday, immediately after the Fed releases its statement, I will inform my readers exclusively through my free newsletter whether The Force was with Ben Bernanke and evaluate the extent to which he was able to execute the mind trick successfully.

If the mind trick is executed well, both equity and fixed income markets should rally; if not, there will be a disturbance in The Force, and financial markets will find themselves in a considerable pickle.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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