This post will be a little controversial. I believe that most investors over- or under-estimate the Fed. There are two ways to mis-estimate the Fed: power and wisdom. With respect to power, the most common errors are to overestimate the Fed in the short run, and underestimate them in the intermediate run. With respect to wisdom, the errors are to think that they are the wisest player in the market, or that they are less wise than the average market player.

My hypothesis is that the Fed is one of the brighter players in the market, top quartile, but not top decile, and that their power is quite great toward the end of the cycle, but modest until then.

My first contention stems from the lack of scalability of intelligence in a bureaucracy. You can gather large amounts of information, and have bright people interpret it, but the large numbers of Ph.D. economists insures that the result will tend toward consensus, and not be that much different from the consensus of economists outside the Fed, which means that the Fed will miss turning points. Also, in a bureaucracy, political pressures often dominate those near the apex of the organization, which twists the interpretation of the data, as well as what is deemed to be data. (M3 is no longer data worthy of being calculated.  A mistake in my book; the cost savings were minuscule, and the measure told us a lot about credit that M2 does not.)

Also, because of our political culture, there is a bias toward making it look like you are doing something, even when doing nothing is the optimal policy.  (We would likely all be better off by having Congress be a part-time legislature.  Okay, sorry, formally a part-time legislature… they have a lot of vacation already.  The same would apply to the Executive branch, but it would mean reducing the number of regulations enforced.)  So, even if the Federal Reserve is correct about the right long-term strategy, political pressure can force a different policy action, at least in the short run.

The Fed is a political creature, and it prizes its independence.  The funny thing is that it often preserves its independence by giving in to the political pressures that threaten its independence.  E.g. employment is slightly weak, but present policy is adequate to handle it if we wait 12 months?  No problem, we’ll loosen policy further.  (We can always take it back later, right?)

I would argue that no, you can’t take it back.  Yes, the Fed can reverse the cut later, but the effect is not the same as if they had not done the additional cut.  Here’s why, and this speaks to the power of the Federal Reserve: when the Fed lowers rates, more assets become financable at the lower short-term interest rates.  The lower rates go, even if for a time, the more economic players think that they can afford a given asset.  The effect is slow at first, because there’s a threshold to be met for psychology to change.  Changing the financing cost by 5% is dust on the scales; it’s not worth the fixed costs and effort.  Changing it 10, 20, or 30% is another manner, and cheap short-term capital will lead many to speculate and bid up asset prices, whether the assets are housing or businesses.  Economic activity accelerates accordingly.

It also takes a while for policy to bite when rates are rising.  Homeowners and businessmen make adjustments as rates rise, but it takes more of a rise to make their free cash flow go negative, forcing unpopular decisions that may have large fixed costs.  Asset prices normally decline in such an environment, slowing down economic activity.

My contention is that in order for Fed policy to have real impact it has to move the short rate significantly.  Time is not what does it, but the amount of the move.  Because the Fed moves slowly, the two effects become confused.

Back to my original questions.  How powerful is the Fed?  Very powerful when they move rates far enough, but weak before then. How wise is the Fed?  Pretty smart, but hamstrung by politics and bureaucracy, which keeps them from implementing the right strategy even if they have it.  They don’t always have the right strategy; they still miss turning points the same way that external economists do as a group, and often their actions add to economic volatility by being accidentally pro-cyclical.

The question that I have at this point in the cycle is how low the Fed will get before they get scared about inflation, and flatten out policy to see which effect is larger — deflation from overvalued housing assets purchased with debt, or inflation of goods and services prices.  They are separate phenomena, and can occur at the same time.  If they do occur simultaneously, what will the Fed do?  The US has almost always been debtor-friendly, so I would expect inflation, but that is just a weakly held opinion for now.

If you are looking for more of me to read, pick up a copy of the November 2007 MoneySense magazine for my article “Nerve Medicine.”  It describes five points on risk control for individual investors.  Thanks to MoneySense for publishing my article.  The magazine costs only C$5.50 at the newsstand.  That’s about $6.00 US, right?

As an aside, to editors of publications that peruse my blog, I am available for other writing assignments.  I enjoyed writing a longer article for a retail audience, and would accept the challenge again.  E-mail me if you have interest.