If you have defective and obsolete models, you will produce incorrect analysis and bad policy every time.
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There’s no better example of this than the Federal Reserve.
The Fed uses equilibrium models to understand an economy that is not an equilibrium system; it’s a complex dynamic system.
The Fed uses the Phillips curve to understand the relationship between unemployment and inflation when 50 years of data say there is no fixed relationship.
The Fed uses what’s called value-at-risk modeling based on normally distributed events when the evidence is clear that the degree distribution of risk events is a power curve, not a normal or bell curve.
As a result of these defective models, the Fed printed $3.5 trillion of new money beginning in 2008 to “stimulate” the economy only to produce the weakest recovery in history. Now, the cycle of monetary tightening has been ongoing in various forms for over five years.
First came Bernanke’s taper warning in May 2013. Next came the actual taper in December 2013 that ran until November 2014. Then came the removal of forward guidance in March 2015, the liftoff in rates in December 2015, four more rate hikes (so far) in 2016 through 2018 and the start of quantitative tightening in October 2017.
During much of this tightening, the dollar was actually lower because markets believed the Fed would not raise in the first place or was overdoing it and would have to reverse course. Now that the Fed has shown it’s serious and will continue its tightening path (at least until they cause a recession), markets finally believe them.
Another rate hike is already in the queue for June 2018.
The Fed is also burning money now by reducing its balance sheet on the assumption that this reduction in money supply will have no material adverse impact on capital markets.
Tighter monetary conditions in the U.S. are leading to a stronger dollar, capital outflows from emerging markets (EMs) and disinflation.
A stronger dollar is itself a form of monetary tightening. A stronger dollar cheapens imports for U.S. buyers because they need fewer dollars to purchase goods. That’s a deflationary vector that will make the Fed’s goal of achieving inflation even harder to reach.
Add it all up and the U.S. is now getting a triple shot of tightening in the form of higher rates, reduced money supply and a stronger dollar.
At this rate, we may be in a recession before the end of 2018 unless the Fed reverses course, which they may well do by this September or December.
Meanwhile, market distress is emerging from Argentina to Turkey. Emerging markets are suffering one of their worst collapses since the infamous “temper tantrum” of May–June 2013.
Fed Chairman Jay Powell says Fed “normalization… should continue to prove manageable” for EM economies. But the EMs are already in distress. Just ask Argentina, which turned to the Bank for International Settlements (BIS) and IMF recently for emergency rescue loans.
To repeat, the Fed has it wrong again. The situation in EMs will get worse before it gets better, and the Fed will be the last to know.
We’ll see if the Fed wakes up to the danger before it’s too late.
But its record doesn’t exactly inspire confidence.
This article originally appeared on The Daily Reckoning.