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The Fed's Jedi Mind Trick

Stocks in this article: ^DJI ^GSPC TLT JNK SPY QQQ DIA

The current problem is that as risk aversion subsides and liquidity preference becomes more normal, the entirely abnormal liquidity balances sloshing around in bank and money market accounts have begun to be deployed by business and individuals.

Thus far, most of these deployments (and the attendant acceleration of monetary velocity) have been directed to the purchase of investment goods, causing the prices (and volumes) of assets as junk bonds and stocks represented in index ETFs such as SPDR S&P 500, PowerShares QQQ and SPDR Dow Jones Industrial Average to rise. By contrast, relatively little of the excess liquidity in the financial system has flowed into the real economy to stimulate the production of goods and services.

Going forward, the risk is two-fold. First, incipient asset inflation in certain assets such as junk-bonds, stocks and real estate can turn into a full-fledged speculative bubble as households and businesses with abnormally large cash balances rush not to miss out on the boom.

Second, the liquidity that does manage to find its way into the real economy will tend to flow into the most profitable sectors that are already hot and are in many cases already experiencing tightness in labor and product supply conditions. The consequence will be price rises in those sectors and dangerous relative price distortions in the real economy, as the prices of some goods and services rise sharply while the prices of other goods and services continue to fall or stagnate.

I believe that most Fed officials are aware of these problems and understand that it is imperative that QE not only be wound down but that liquidity be reined in. Nevertheless, the fact of the matter is that it is not the Fed's legal mandate to prevent asset bubbles and relative price distortions. The Fed's legal mandate, as established by Congress, is to promote full employment and overall price stability.

Please note that regarding the second mandate concerning price stability, the Fed defines it with reference to core CPI inflation, which is simply an average of many prices. Unfortunately, the Fed has never acknowledged relative price stability as part of its mandate, despite the fact that relative price distortions (caused by some prices rising rapidly while other prices fall, stagnate or rise less quickly) are far more damaging to the economy than across-the-board price inflation.

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