What frogs can tell us about the Fed
If you plunge a frog into boiling water, it will immediately jump out. But if you place the frog into cool water and slowly heat it to boiling, the frog won't notice and will slowly cook to death.
Yes, it's a terrible visual. But because so many people have used this analogy to describe the Federal Reserve's exit from easy monetary policy, I thought it worth exploring its flaws.
As human beings our internal thermometers measure the local temperature, sweating to cool or shivering to warm ourselves as we attempt to maintain a body temperature of 98.6. But cold-blooded animals like frogs maintain their temperature to that of their immediate environment.
The Fed and Chairman Ben Bernanke know they must end their quantitative-easing program at sometime, and the obvious debate has been whether they do it quickly or slowly--hence the amphibian anecdote.
My friend Dan Ariely , an expert in the field of psychology and behavioral economics, points out that some prefer long slow pain to short intense pain. However, I believe that the latter is what the Fed has chosen.
Thus, Bernanke floated the trial balloon of quick sharp pain in June and the market sold off hard and fast as interest rates jumped dramatically. The S&P 500 fell to 1575 or so on that dip, but then as Fed spokesman walked back the panic, applying some salve to the wound as the markets recovered to new highs.
Then, on round two of the quick/intense pain, the markets sold off and interest rates jumped, but we are still well above the June lows.
So my trader instincts tell me that the central bank is going to desensitize us with quick and intense shocks, rather than a slow and painful boil. And thus far, the strategy seems to be working.
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