One of the most important lessons that can be learned from probability theory is that the shorter the time horizon one assumes, the more the world appears to be random…even if the odds of a particular outcome are quite high over a longer period of time. This is the reason given for focusing on a process of decision making that derives from a tested model or schema rather than short run outcomes. It is why we need to focus on the underlying situation rather than current headlines that we read daily in the newspaper or hear on the TV monitors.
Currently we are reading about the stabilization of the value of the U. S. dollar, but it depends upon the currency we are talking about. We are hearing that the economy is in a recession…or it is not in a recession. We listen to the speeches and testimony of the Governors of the Federal Reserve System and the Presidents of Federal Reserve district banks and they don’t give us a consistent picture of the economy or of the future of monetary policy. The Secretary of the Treasury puts out frequent optimistic comments, but no action occurs. Furthermore, are commodity prices near their peak…or not? What about inflation? What measures of inflation really provide us with the future direction of prices? The CPI? Housing prices? Oil prices? And, so on, and so on.
All of the above issues relate to short term outcomes. They emphasize what has happened and not what forces are in play that will produce future results. These outcomes distract us from concentrating on the fundamentals of the situation and whether or not anything has changed in these fundamentals.
For example, is there any evidence coming from the current administration that would lead us to think that their economic policies have changed or are going to change? This is an administration that will be out-of-work in eight months…or less. Their options are limited…and they have little or no creditability within the world financial community. All they can do now is to try and talk a good story.
Even in terms of monetary policy, the administration has little room to maneuver. The Federal Reserve responded earlier this year and resolved the liquidity crisis. Financial institutions now seem to be working through the solvency crisis in a relatively orderly way and we can hope that this crisis will continue to lessen in future months.
However, no one really knows what damage has been created on the other side of the equation. The Federal Reserve has produced all sorts of innovations in response to the liquidity and solvency problems and no one has any real idea of how all of this will work out. We are told that the auction facility will go away once things return to normal. Will this really happen and will the Fed return to the traditional form of monetary policy…open market operations in U. S. government securities? What will happen to all of the debt the Fed has taken on in exchange for government securities? How much excess liquidity has the Fed created as a result of all of this activity? Will this liquidity result in more inflation? For example, the broad measure of the money stock has shown some accelerated growth in recent months. Participants in world financial markets continue to be concerned about the Fed monetizing a larger proportion of the government debt that has been created in the past six years.
What has changed? Now that the liquidity crisis has been resolved and the solvency crisis seems to be working itself out, will the Fed begin to raise interest rates to strengthen the dollar? Has the situation altered so much that in the waning days of an administration that already carries with it the legacy of a major financial disruption and possible economic collapse, that the Federal Reserve will start raising interest rates to combat inflation and fight the decline in the value of the dollar? Might the Federal Reserve really reverse itself in the near future?
And what about the basic economic fundamentals? Financial institutions may be working through their balance sheet problems and housing prices and construction may be nearing a trough, but now there are other organizations and industries that must restructure as a result of the change in the economic climate. The auto industry, the retail trades, and others, have only begun their adjustments. How will this round of restructurings change the whole picture?
And what about the events that are taking place in the rest of the world? What about the price of food? What about the price of oil? What about other central banks holding interest rates constant or even raising them to fight their inflation battles?
The obvious point of this discussion is that we may be experiencing some stabilization in some markets…for the present…but, the basic fundamentals have not changed. After a market run, one way or the other, markets may take a breather and consolidate for a while, waiting for new information which points to whether or not the markets should rise or fall. In this short run, however, much of the new information will appear to be random. That is why the question must be asked…has anything fundamentally changed?
In my mind, the players and their messages have not changed. Nothing much is going to change on this front for a while. Therefore, we are pretty much in the same place we have been. Some short run difficulties have been avoided, but this does not resolve the longer run issues. Dislocations exist within the economy and we will not get back to a more stable and productive environment until these dislocations are resolved. We are not out-of-the-woods yet, and there still may be some further shocks. In this respect, I see no reason to become more optimistic about a return to a stable and growing economy in the intermediate term.