Friday, September 14, 2012

Bernanke's Terror Alert Scale

Since I'm such a frequent critic of Federal Reserve policy, I'm pretty sure there's no way I can let yesterday's "aggressive", "unprecedented", "open-ended" announcement of what amounts to permanent quantitative easing ("QE") go by without comment. Indeed, I won't.

There's about a million different angles from which I could attack this latest policy announcement (it's desperate, it's ill-timed, it's dangerous, it fans the flames of inflation at a time when the economy can ill afford it, it jacks up the Fed's balance sheet leverage to astonishing and terrifying levels, it makes me wonder just how freaking bad things are out there if the Fed feels like this is a "reasonable" step, and it therefore isn't exactly confidence-inspiring), but I'm not even going to bother with any of those approaches. Instead, I'm actually going to celebrate (yes, you heard me), because this means that the end of the era of Fed-manipulated markets is now imminent. The Fed fired its last meaningful bullet yesterday, and now the endgame is at hand. Let me explain what I mean.

In the immediate aftermath of 9/11, the newly-created Department of Homeland Security unveiled its "Homeland Security Advisory System" (better known to most as the "terror alert level" or "terror alert scale"), a color-coded, semi-ambiguous chart indicating just how scared we all should be of a terrorist attack at any given moment. The intent of the program was in large part to impact the psychology of citizens, making them more vigilant and aware of their surroundings when times warranted.
Unfortunately, the terror alert scale was an utter failure. Since the level was essentially always set to either "yellow" or "orange", nobody ever really paid any attention to it. It simply became a part of the background noise, consistently ignored because of its ubiquity. People are able to remain vigilant and aware only for short periods of time—when they're asked to do so for years at a time, they simply become complacent. Not surprisingly, the terror alert scale was eventually retired, presumably still set to "orange".

The Fed's latest QE program similarly attempts to impact the psychology of the American citizens—if consumers and investors know that the Fed is committed to always printing money, they'll be more likely to step out on the risk scale and start spending and investing money (while it's still worth something) rather than waiting around until tomorrow. It theoretically creates a certain sense of urgency that the Fed has been laughably unable to instill up until now.

Unfortunately, perma-QE is likely to fail in the same manner that the DHS terror alert scale ultimately failed. Sure, QE-∞ will cause a Pavlovian short-term rally in the markets, just like the terror alert scale caused us all to be super-vigilant at airports for about 3 months. But sooner or later, this perma-QE will just fade into the background like the "orange alert" that we all ritualistically ignored after a while.

The simple fact is, "QE always" is "QE never", just like anything else that was once rare but then became ubiquitous (like, say, a college education). Once a new baseline expectation has been set and adjusted to, this "easing" simply becomes part of the landscape, and it will become increasingly difficult—if not impossible—for the Fed to effect incremental change. In all areas of life, ubiquity brings along with it an ironically increased invisibility—call it the paradox of ubiquity. Ubiquity breeds irrelevance, for Fed policy just like anything else.

To date, previous QE programs have been effective because they have been sudden, strong, and powerful—like a quick shot of cold air on a hot summer day. But once we've turned the AC on full blast and left it there for months at a time, does anybody even notice it anymore? Or do they only notice when it's taken away? I'd argue the latter, which means that the days of the Fed influencing the market with incremental policy proposals are largely in the past.

So as I said to lead off this rant, the Fed has now fired its last meaningful bullet (some intrepid journalists in fact called it a bazooka), and it sure as hell better work and work quickly. Because if it doesn't, they're going to have to do something far beyond drastic to ever have any impact on the economy (or markets) again, now that they've made permanent QE the baseline.

At some point in the not-too-distant future, the market will experience another correction, and the economy will tilt into another recession. The question is, what will the Fed do then, and will it have any impact whatsoever? The Bernanke Terror Alert Scale is now definitively set to "red"—to have any future effect, Bernanke will have to invent a new color, and I for one don't think that's possible.

So congratulations, Chairman. You've seemingly pulled off the impossible and printed yourself into irrelevance. Enjoy these next few weeks or months of Fed-fueled market rallies while you can—I'm betting this may be the last time you'll ever see them.


  1. Hello CC

    One question - is there no impact of this latest bout of QE outside of the impact on "market confidence"? Where can I read more?

    1. Big Al,

      What's up, man? Thanks for reading. There are a number of theoretical justifications for QE, but pretty much all of them come back to the "wealth effect", which is described here: and here:

      The general concept is that as people feel richer (because of rising stock and/or house prices), they'll be willing to spend more and that will create economic growth. I happen to think that's a load of crap, because people will only spend if they perceive their wealth gains to be permanent--and after the crashes of the internet bubble and the housing bubble in the last decade, people are increasingly skeptical and cautious in that regard.

      Ultimately, I think that all QE does is fuel asset price bubbles, which can then be devastating when they eventually burst. Therefore, QE amplifies the recession/recovery cycle, generally destabilizing the economy and preventing the development of a healthy and sustainable capital base.

      If you still want to read more, I happen to think that this piece by David Einhorn (written earlier this year, before QE3) was one of the best and most accessible piece on the topic that I've ever read: It also makes reference to The Simpsons, which makes me smile. Enjoy. Hope all is well.