The generic assumption is that any government agency is out-of-touch and ineffectual. There may be a truth to that, but it doesn’t mean that the individuals in charge are not actually trying to do their best. Neither should we assume that they are all stupid.

With the next Federal Reserve meeting coming up this week, it is worth reviewing the Central Bank’s dilemma.

Investors can be divided into three main camps:

  • Economy is fine. Inflation pressures are rising. The Fed should and will hike soon.
  • We are heading into recession. Deflation pressures are rising. The Fed will not hike anytime soon.
  • We are heading into recession. Deflation pressures are rising. The Fed will hike soon and make things worse.
  • As I have written before, I have my own small camp:  “Economy is fine (at least in the USA) AND deflation pressures are rising”. See my post from March 22nd, 2015

    It is important to understand that each of those camps has strong arguments and statistics to back their position. Anyone with an open mind should be wary of being completely convinced when so there are so many strong counter-arguments.

    As my readers know, I have critiqued Bernanke’s Fed before and I am a bigger fan of Janet Yellen. But whoever the chairperson is, the occusation of being an out-of-touch academic hangs over their head.

    Now, as a former academic I can tell you: intelligent people are aware of the differences between models and reality, regardless of their theoretical background. They are aware of the risk of being out-of-touch and are trying with all their not inconsiderable resources not to be.

    Now let’s assume that Yellen is familiar with all of the current schools of thought and is not completely convinced by any of them. What is the safest course?

    If the Fed followed the hawkish docrine and hiked as early as June, they would have risked the runaway dollar strength and destabilization of global economy, which would eventually backfire domestically.

    On the other hand, pushing the hiking cycle indefinitely has its own risks. Arguably, ZIRP can lead to a dangerous rise of leverage and price distortions. In the recent months, as the market had started expecting a more dovish Fed, the long bonds actually collapsed. It is hard to be sure how much of it was just positioning and how much the erosion of the central bank’s credibility, but the consequences could be counterproductive for the economy.

    Thus the current procrastinating stance of the Fed:

    “We will hike sometime soon, honestly. Just not today.”

    One could argue that their information is not likely to become much more conclusive soon. But such indecisiveness may paradoxically be the most benevolent course:

    • The pace of the dollar rise stays under control
    • Rate expectation are kept away from zero to prevent a complete party in the short-end

    So is it possible that the Fed is actually smarter than we think? That they are doing there best to guide their boat between Scylla and Charybdis?

    Should we expect more of the same: “just not today?”

    Image “Between Scylla and Charybdis” by Cea.

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