I’m From the Fed, and I’m Here to Help You

Izabella Kaminska writes very interesting posts at FTAlphaville.  She finds unusual things in the markets, including the commodity markets, and writes about them intelligently and provocatively.  I have to take issue, however, with one of her more recent efforts.

She takes as her inspiration an article by the improbably named (to an American ear, anyways) Hilda Ochoa-Billembourg.  Izabella’s takeaway from HOB (you didn’t think I was going to type that again, did you?) is that the Achilles heel of QE2–which, remember, was specifically designed to produce some inflation–was that it did not produce the right kind of inflation (something which Bernanke adamantly, and not too plausibly, denies):

If you work with the premise that QE2 led to what has been described as ‘bad inflation’ — inflation being exported into commodity and emerging market securities rather than domestic ones — you could argue the Fed has always had an interest in sterilising that inflation effect.

What to do then?  Have the Fed intervene in the commodities markets by selling longer-dated futures, of course!  Kaminska suggests that the Fed–or some Government Body To Be Named Later–did this, although her argument here is highly circumstantial and, uhm, speculative.  Now that deflation fears are reviving given the European tumult and the palpably slowing US economy, she suggests that it could be just the right time for the Fed or GBTBNL to buy commodity futures.

Or not.  I have problems with the argument from start to finish.  It is predicated on the view that speculators are driving the curve (although Kaminska admits that it doesn’t affect spot prices)–a highly dubious proposition.  It presumes a sort of disconnect between the Treasury market and the energy (and other commodity) futures markets (“One might even say that the market has shifted from expressing inflationary views via the Treasury market to the oil market.”  If so, there’s money to be made!) Although she recognizes–blessedly–that speculators affect the risk premium embedded in futures prices, she confounds a risk premium with an inflation expectation effect (which should be impounded in the interest rate terms structure in any event).  Most notably, she makes the all-too-common mistake of confusing Keynesian contango/backwardation–which is a difference between a spot price and an unobserved expected future spot price–and contango/backwardation of the observed curve, which is the difference between traded prices.  (An expected spot price is not traded.)    The risk premium can change without having any impact on the shape of the futures curve; the effect of the risk premium–and hence hedging/speculative balance–on the futures curve is indirect, operating through the effect of the risk premium on inventory decisions: roughly speaking, more Keynesian backwardation (hedgers pay speculators a greater risk premium) leads to less inventory which tends to reduce the contango/increase the backwardation in the curve.  But detecting this effect is hard even in a simulated market, let alone in a real one.  Her story also depends on an implausible relation between speculation and the Brent-WTI spread.

But put all that aside.  Assume it’s all correct.  Do we really want the Fed, or any other GBTBNL, monkeying around with still more relative prices?  Really?

Several times I’ve recounted the story of the great economist Sherwin Rosen, who in 1982 startled an 830 AM section of his Econ301 class at Chicago by shouting: “And that’s the problem with inflation.  It FUCKS UP RELATIVE PRICES.”  Well, of late the Fed apparently thinks that effing up relative prices is its job.  Heretofore, its efforts (unless Izabella is right that the Fed has been active in commodity markets as well) have focused on the yield curve and inflation expectations: twisting this rate relative to that–or is it torquing?

How is that working out for us?  Trivial growth in the H1 2011.  And how about that last jobs report!  Or should I say, that no jobs report?

We really don’t need it attempting to affect–to f*ck up–the relative prices of commodities or anything else.  Indeed, the now common diagnosis of the failure of QE2 (which you might have read here first, well before its end) is that the Fed’s intervention screwed up relative prices: forcing down the dollar, which induced other countries to intervene to prevent undue appreciation of their currencies, thereby sparking inflation in emerging markets, which has led to yet further policy responses; forcing up commodity prices, which put a drag on developed economies.  So we should now believe that there will not be any unintended consequences on other relative prices from an attempt to intervene into the commodity markets?  Really?

The probability that the Fed could somehow tweak relative prices just right this time based on a theory that would do Professor Irwin Corey proud, and which could use a good trip to the barber for a shave with Occam’s razor, is vanishingly small.  The probability that it would wreak yet additional havoc through such an intervention approaches one.

The problems are almost beyond numbering.  There is the knowledge problem: how could the Fed possibly know what the “right” relative prices are?  There is the implementation problem: how could the Fed actually achieve the relative prices it wants to, if by some miracle it could divine what they should be?  There is the strategic/expectations problem: how could the Fed succeed given that it would not be acting on automotons, but on live, thinking, reactive, strategic actors who respond to the Fed in ways that are hard to predict?

No, as Sherwin might say if he were still alive: the Fed has f*cked up relative prices enough, thank you.

So Ben, et al: Stop before you do even more damage, and inject more uncertainty into an economy that is already reeling from it.  We need no more Sorcerer’s Apprentice interventions.  Don’t just do something, stand there.  Become what you were intended to be–a lender of last resort to address liquidity problems and banking crises–and stop trying to be some grandiose central planner that manipulates price signals to achieve some “aggregate” outcome.  It hasn’t worked up to now, and it won’t work any better if you double down.  Do more by doing less.  Go away and leave us alone.

In brief, we may need to revise Reagan’s statement of the ten scariest words in the English language: now, it should be “I’m from the Fed, and I’m here to help you.”  With help like this . . .

About Craig Pirrong 223 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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