Consequences of market manipulation

The Fed has maintained a counter-cyclical monetary policy because it is thought (I contend our sample size isn’t large enough, but in a few years I think we’ll get a good feel…) that “leaning against the wind” leads to less volatility and less overshooting in the long run for the economy and interest rates. I think it merely allows marginal companies to survive, rather than flushing the system of debt and reallocating resources more efficiently but with pain, and weakens our banking system over time as it is encouraged to take more risks.

But, there is a limit to the amount of damage the Fed can do by setting targets for the front end. While the rest of the curve and other interest rate products tend to follow, they also are free to have a mind of their own (especially further out in duration). The Fed has lowered front rates as far as they’ll go, but now wants mortgage rates lower so as to hopefully arrest the fall in housing prices. I think Ben knows what he’s getting himself into, and the final result (which he likely foresees) is that we will have a slow grinding adjustment in housing prices rather than a quick and violent one. With mortgage rates being held artificially low, an artificial demand for housing will exist in the market until the manipulation is halted and rates are allowed to return to market clearing levels. Theres a lot of benefits to this approach — it gives banks time to earn their way out of this mess and hopefully recapitalize faster than losses mount (I think it’s debatable whether slowing price drops at this point will make much difference, maybe he foolishly thinks he can turn the whole market without destroying the dollar…)

There are a lot of drawbacks too, and Fed purchases of MBS and suggestions by Felix and others that they should purchase other assets further out in duration than current programs, like Corporates, will only compound these drawbacks. The Fed is essentially replacing market forces, the invisible hand, with its own thoughts on asset valuations. Sure, right now we have banks that are essentially backstopped by the Gov’t allocating this capital, why not just let the Gov’t themselves do it (I think Interfluidity recently brought this up also) and ignore the profit motive? Profit is what makes capitalism work; even if it’s a call option instead of pure equity it’s certainly better.

Maybe these assets are undervalued right now (I would disagree vehemently, even though liquidity is so low) and they are correct in buying, but when will they sell? Models & Agents, a blog that’s new to me, is also concerned about the way the Fed is beginning to dictate who gets credit and who does not. The real cost of these programs is not the gross $ amt spent to purchase MBS or bonds, or even the net $ amt after taking into account sales prices and coupons (whenever they are sold, or likely held to maturity) , but rather the impossible-to-measure impact these false, manipulated, market prices has on the pricing of other assets. And with manipulated asset prices, we open ourselves to the certainty of misallocation, further misallocation might I add, of resources in our economy.

At this point I’m convinced we are headed to a slow grinding decline, both economically and politically. The Fed will continue trying to hold up asset prices to the detriment of our fiat currency. It is a sad state of affairs when the leaders of capitalism become too scared to take the associated pain that comes with the territory and think there is no drawback to taking pain killers and continuing on their merry way. We need to flush the system out, or we’ll be stuck making shitty cars and building McMansions 100 miles from civilization for the foreseeable future.

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