I need to start off by saying I am a big fan of Robert Shiller’s. “Irrational Exuberance” and “Animal Spirits” were excellent books, pointing out so many of our cognitive shortcomings in all things financial. And “Irrational Exuberance”, which was strongly recommended to me by David Lipton in March of 2000, about a month before the peak of the Tech Bubble, probably saved me a good deal of money as well. Moreover, these books came at times when the reigning ideology was ‘the freer the market the better’. Shiller was certainly swimming upstream by driving home the point that markets fail. The growing relevance of behavioral finance owes a lot to his work.
At the same time we have Robert Shiller, financial evangelist. He has long been a font of ideas on how financial education and innovation might make our lives better. And this brings us to the problem: How can a man who believes human nature is magnetically drawn to stories over facts, momentum over mean reversion, believe, for example, that encouraging the average person to hedge his/her home value in a futures market will not likely, at some point, end badly? If markets do fail, and if the frequency of market failure seems to be positively correlated to financial innovation, why would anyone want to give people even more weapons with which to hurt themselves?
This at its core is really a version of the very same problem Alan Greenspan had some years back. On the one hand, Greenspan asserted that financial innovation in general and derivatives in particular would be used to dampen market risk, not increase, because banks’ were profit maximizers, and their incentives meant we could trust them to self-regulate. And we know how that turned out. On the other, however, his book “The Age of Turbulence” explained various market crises under his watch by pointing out that the psychology of crowds, when under pressure, cannot be counted on to do the rational thing. Often, he argued, this negative psychology was self-reinforcing and there was little one could do to stop it.
It is conceivable that Shiller is at some level just being naïve, and that he believes with sufficient education we can overcome our animal spirits. Personally, I think it is a bridge too far, and Robert Shiller, like Greenspan, by advocating democratization of financial innovation while arguing that human nature is hard wired to make bad decisions, has succumbed to his own little version of cognitive dissonance.
This morning’s employment data were not dramatically out of line with the current trend. They did, however, fall meaningfully short of expectations—especially at a point in the recovery where data have historically tended to surprise to the upside. And even though nothing about this crisis and recovery maps to other periods we have lived through, this has to be seen as a significant disappointment.
But it would be wrong to think that this will significantly alter the Fed’s reaction function come September 18th.
Beyond the obvious that the Fed—unlike those of us in the market—is unlikely to overreact to one data point, there are three reasons why the Fed is likely to stick to its current course and that odds still favor a September tweak to their current policy stance (read taper).
One, the Fed thinks in balance sheet terms. We in markets are slaves to flows, but the Fed all along has said that to the extent QE has a mechanistic effect on financial conditions it comes through reducing the available stock of USTs and mortgages to financial institutions and the broader investing public. And the fact the yields have tended to go higher when the Fed initiated purchases under its series of programs, but each time to lower highs—notwithstanding improvement in the economy—supports its case. In short, the Fed doesn’t view taper as reducing accommodation.
Two, the Fed is increasingly cognizant of the data that suggest QE has passed through to the real economy much less than its staunchest proponents hoped. At the same time collateral costs—though far, far smaller than hard money advocates had forecast—have been creeping higher. At home, markets have been distorted in exchange for less benefit. And abroad, to paraphrase the famous John Connolly quote: the Fed is our monetary policy, but your problem. Both the risk and the reward may have turned out smaller than many hoped/feared, but be that as it may the risk-reward equation still continues to drift away from more QE. And the Fed gets this.
Three, it’s all about the signal. QE has triggered significant effects in markets and indeed helped buy precious time for household balance sheets to heal and animal spirits to revive. This has been an important contribution. But it is now clearer that the primary channel through which this has taken place is psychological. Most everyone now knows that the money “pumped in” by QE has largely remained as reserves on the balance sheet of the Fed. The money that “flowed” into asset markets here and abroad came from us, not the Fed, as our risk appetites increased.
It was virtually impossible for the Fed to have gauged ex-ante the magnitude of our psychological response to its easing. But because the market response has been so large yet the economy is still far from where the Fed would have hoped to see it by this point in time, the weaning of market psychology off of the Fed teat now has to be handled in a balanced and incremental fashion. Signaling will play a central role in this process.
The Fed already took the first step in this process. Many Fed members seem anxious for the data to let them take that next step. And this morning’s data won’t do much to alter this monetary landscape.