Hussman Weekly Market Comment: Psychological Ether

“It’s quite possible that even a small taper will be too much for investors, but the alternative to tapering is to make an already precarious situation more precarious, while damaging the Fed’s credibility in the process.”

Hussman Weekly Market Comment, Baby Steps, September 16, 2013

Last week, the Federal Open Market Committee (FOMC) decided to go the alternative route. The Fed’s decision does not seem intended to be a “reset” of perpetual quantitative easing. Instead, it appears to reflect the committee’s belief that QE has real economic effects, but that these economic benefits have not gained sufficient momentum. Notably, one member of the FOMC who voted in favor observed on Friday that the decision not to reduce the pace of quantitative easing was a “borderline decision.” Another voiced concerns that the Fed now faces “challenges that come with issues of credibility” and that the inaction “discounts the potential costs of the policy tool with which we have limited experience.”

In my view, the problem with quantitative easing is that its entire effect relies on provoking risk-taking by those who would otherwise choose not to do so; that the FOMC has extended and amplified financial market distortions without regard to the rich valuations and dismal prospective returns that financial assets are most likely priced to achieve; and that this distortion of financial asset prices has precious little to do with the presumptive goal of Fed policy, which is greater job creation and economic activity.

Unfortunately, even though the equity market has been rising on what we view as nothing but noxious psychological ether, the FOMC has – perhaps unintentionally – released another tank of the stuff. Quantitative easing only “works” however, to the extent that investors have no immediate desire to hold short-term, risk-free assets. In any environment where investors become eager to hold currency and other low-risk, default-free assets despite their low yield, I expect that both investors and the Fed will discover that quantitative easing is wholly ineffective in supporting the prices of risky assets. This is an experiment that has not yet run its course, and we have no intention of being the guinea pigs in that study.