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Why The Fed Can't Stop The Next Market Crash

Submitted by Gregg Janke via TaoMacro.com,

In the last article I wrote I indicated why a stock market crash may be imminent.  The reasons I gave included:

As early as January 2014 we reached a point of Sornette finite time singularity, indicating the market may have reached a point of instability consistent with bubble market tops.

 

The fact that market valuations were at an all-time high, second only to the extreme bubble peak of 1999-2000 era; when measured by more comprehensive metrics like market cap to GDP ratios.

 

Deflationary pressures mount. The overall economic trend has been one of deflation due to the malinvestment of the credit and debt buildup of the past decades.   The velocity of money has been on a continuous decline for a while, and is now at record lows.  It is not just oil that is crashing, but the entire commodity complex has fallen sharply in the last few years.

 

The Federal Reserve has stopped printing money, which was the impetus for the rise in the market.  It’s a ways off the next phase transition of what its policy regime will need to look like in order to move sentiment back in the other direction. 

In this piece I would like to expound on the last part of why the Fed will not be able to prevent the next crash.  The recent debate surrounding Fed policy is whether or not they will start to “normalize” rates by beginning with a 25 basis point (0.25%) rate increase in the short term rate.  I contend that this debate is somewhat moot, especially once the market has initialed a waterfall selloff.
 
When Janet Yellen decided to keep rates unchanged there was an initial jump in the markets, and then another sell off.  Now apparently she is serious about raising rates in December.  All this attention to a mere 25 basis points at best amounts to an additional potential trigger for the timing of the next market crash.  More likely its real value is just more political theater from the Fed, which is really all they are good at.
 
The market is already over bought, overvalued, has started its decline, and is in an unstable state.  The crash will happen regardless of the endless number of random reasons attributed to it triggers.  The key question is, what will the Fed do when this happens?  Certainly the discussion of the 25 basis points becomes entertainment at that point.

The Fed has truly run out of easy options.  They are boxed in a set of circumstances of their making.  They operate under the auspices that they are the sole institution with the knowledge and tools to navigate one crisis to the next; when in reality they are the creators of the crisis in the first place, by blowing up one bubble after the next.

The last two recessions have seen a dramatic diminishing return of the policy tools the Fed has used.  There has been a complete phase transition from one recession to the next.

This chart shows the difference between the policy responses of the Fed Funds rate (Short term rate) after the Tech Bubble and the 2008 crisis.
 

The 2008 crisis required a much more aggressive change the in the Federal Funds Rate.  It had to be brought down to zero and held there indefinably (Until this December when they raise it…no really)

This chart shows the difference in the monetary base, reference the Fed’s choice to introduce Quantitative Easing (QE) in response to the 2008 crisis.
 

The Red area indicating the money printing after the 2008 crisis was truly unprecedented in U.S. monetary history.  It marks the end of world reserve currency credit induced expansion we have had for quite some time.  Both policy changes of the rates and especially the blow up of the monetary base represent complete phase transitions of the tools implemented by the Fed.  The increase in the monetary base with QE would have been quite unthinkable just a few years earlier.  The debate of what the appropriate response to the two crises were very different; representative the diminishing return of Fed Policy tools.

This required exponential level of change in Fed policy is consistent with Austrian style economic theory which lets us understand that increasing levels of debt and money are needed to keep the game going just a little longer.  Unfortunately for the Fed, the gig is up.  While they struggle to find an appropriate time to introduce a 25 basis point increase in the short term rate, there awaits the next exponential transition into what will be required to stabilize the next crisis.  A crisis that will be worse than 2008 because we are that much more in debt, and the Fed has already used up its easy fixes from the last crisis.   

What will the next transition look like?  If the previous regime of a rate reduction of 500 basis points was insufficient, even NIRP (Negative interest rates) will not work; as we would be talking about an additional few more basis points.  Negative interest rates would also punish savers and those living off fixed income even further.  This would be an awkward and likely unpopular policy to implement.  It also would have a dubious effect on the economy, as we would descend into an even deeper liquidity trap.

The next policy regime will require even more quantitative easing, and perhaps alternative methods of the channel used for injection.  I would expect a broader spectrum of securities purchases by the Fed to perhaps include coordination of a massive expansion in government fiscal stimulus.  The last crisis resulted in the monetary base going from 800 billion to 4 trillion dollars.  The next round of QE will require a multiple of that.

This next chart is not a prediction, but is illustrative of of the exponential nature of the next phase transition of Fed monetary policy.  Just as what was ultimately done after the 2008 crisis would have been considered unheard of prior to the crisis, so too will the next policy implementation be drastically beyond the scope of what is currently being considered.  Such is the nature of the exponential and discontinuous events that face us in a world manipulated by the Federal Reserve.

The Fed was late to prevent the popping of the last two bubbles, and it’s already too late to stop the popping of this one.  The Fed is consistently behind on the timing of when to reintroduce stimulus because its only choice to deal with the bubble it’s created is let it crash, or blow it up even bigger which would result in an even harder landing.  While the Fed ponders when the rate hike comes, our question is: When does QE4 start?