Since March 2015, Keith Weiner of the gold standard institute, United States, contributes on snbchf.com. This post is another great insight for a simple fact that traders often forget.
The topic of whether the Federal Reserve can see bubbles in advance, and what they can do about them, is hotly debated. There is little agreement as to how to define a bubble, if the central bank can actually see one develop, whether it should act, what it could do if it chose to act, or how it could clean up afterwards.
The New York Times DealBook highlights many of the competing ideas. In this article, they say central banks “could have raised rates sooner.” Now they are trying to “show they have learned the lessons,” but “unfortunately, some economists remain skeptical about bubble-fighting…”
They should be skeptical. Janet Yellen, currently Chair of the Federal Reserve, spoke in 2005 when she was President of the San Francisco Fed. At the peak of the housing bubble, she tentatively offered that, “House prices could be high for some good, fundamental reasons.”
As it turns out, they weren’t.
Economic theory explains that central planners can never know what the right price for anything is. This is how economist Ludwig von Mises predicted the collapse of the Soviet Union back in 1921. He said, “The problem of economic calculation is the fundamental problem of Socialism.” He was referring to the absence of prices formed in the market. He continued, “Only so far as they [Soviet rulers] refer to [the West’s] price system, are they able to calculate…”
It takes a market with many different actors including producers, consumers, market makers, and others to determine prices. By contrast, a government policy committee is no market. Neither is a cabal of banks under the committee’s thumb.
And doesn’t that describe the Treasury bond market? The Fed sets the short-term interest rate, and heavily influences long-term rates. The banks play their part, taking the skim offered to them.
The Fed is setting the interest rate—the price of credit. This essential price affects the price of everything else. So it’s not surprising that the Fed doesn’t know when other prices are wrong.
The price of an earning asset depends directly on the interest rate. Warren Buffet, for example, calculates the value of a company by projecting its earnings, and discounting each future year. Next Next year’s earnings are worth less today, earnings the year after are worth even less, and so on. This is because of time preference. It is better to have your cash today than tomorrow. If you are going to give up the use of your funds, then you want to be compensated.
Buffet uses a rate of interest to discount future earnings. A higher rate gives a lower present value, and vice versa. Think of it this way. If you’re getting paid $100 next year, and you discount it at 10 percent, then it’s worth $90 today. However, it’s worth $98 if you discount at 2 percent. For reference the 10-year Treasury rate is 2.3%, though investors may demand a premium to this.
The rate of interest has been falling for over three decades, which means the calculated present value of assets has been rising.
The math is simple. Anyone with a calculator can tell if an asset price is out of range based on its cash flows, such as earnings or rents. That’s not why the Fed can’t spot bubbles.
The Fed’s problem is that the calculation depends on a rate of interest that it heavily influences. Its analysis is therefore circular and self-fulfilling. It’s like taking a picture of a painting. Of course the two images match, but what does it prove?
Asset prices rise in value when the interest rate falls. Therefore, we need to know if the interest rate is right. The Fed can no more see that, than you can feel your own body temperature.
The Fed can’t see the forest for the trees. Or perhaps I should say: it can’t see the bubbles for the soapy water in its eyes.See more for