The Fed’s low signal to noise ratio

The economy seems to lurch from crisis to crisis. The goldilocks years of not too hot, not too cold economic growth have suddenly disappeared. There are many reasons, of course, but they are the symptoms of a bigger problem as much as the cause of our economic distress. The problem is Big Chaos acting at once all over the economy.

It is as though the chaos in the economy created the inflation as much as inflation caused the chaos. The same could be said of Covid. We still have no certainty about the origin of the disease in China. At best it is a secret, at worst, an unknown terror which will revisit us again. The virus emerged when the world was at a particularly uncertain point, during a chaotic trade war with China. The great powers structure of the world economy was developing and so was Covid at the same time. Covid has infected over six hundred million people, disrupting human life at many levels, and infecting our lives with chaos.

Chaos is not new to our economy. It is typical for us to have many indeterminant events embroiling the economy. We usually think of these as irrelevant and uncorrelated. They can be diversified away as a source of unsystematic risk. We usually think of chaos as a risk which does not threaten the core of our economy.

Big Chaos

And it was usually true that the chaos in our lives was limited in scope. But we now live in a time of big chaos from which none of us can easily escape. Big Chaos is a threat to the core functions of our economy, indeed our whole society.

And of course, chaos is an element of our financial lives and needs to be understood analytically. Attempts to integrate chaos into financial theory has gone on in various ways for a number of years with continuing efforts and limited success.

We cannot appeal to formal theories for an explanation of how to deal with the chaos we expect. Today’s chaos for investors is Big Chaos. Big Chaos is not necessarily diversifiable. Big Chaos items are usually systemic. We have Big Chaos when we have wars, climate change, and plagues which threaten the core of our system. Big Chaos is noisy.

And Big Chaos compounds. One disaster feeds another. Climate change produces storms limiting oil production, which causes the reactivation of coal power plants and more greenhouse gasses.

Big Chaos may have altered our risk/return profiles too, raising the impact of Big Chaos on markets. Given the stress which Covid has produced for the human species, one would suspect that investors would have been negatively affected. Indeed, at least one study has enumerated the ways in which Covid has natively impacted personalities. This could have reduced the risk tolerance of investors, driving the market lower even with a neutral Fed, and accelerating its fall as the Fed raised rates.

Noise drowns out Fed

It could be argued that the uncertainty of Fed policy in response to inflation has simply been chaotic. Certainly, it has been at least uncertain. Nor does it appear that Fed policy raising interest rates has materially reduced inflation. That may be a result of weak models like the Philips Curve which suggests that higher rates will eventually slow inflation.

It may also be the result of the Fed message needing to raise its volume above all of the other chaos in the market. The Fed signal is its message that interest rates are rising. That message is to a large degree lost in the sea of other chaos. Essentially, the Fed signal to noise ratio needs to be boosted. The Fed may need to raise rates far higher than it would have needed to do in a less convulsive time. Indeed, Chairman Powell has as much as said so.

But it is a very chaotic world, and we may find one day that a shot of Big Chaos may render the whole inflation issue moot. Inflation may be driven away by war or other means.

Investor implications

1. The Fed will have limited ability to control inflation in this environment.

2. Inflation is an emergent chaotic behavior not subject to simple behavioral controls.

3. Investors may have less than usual risk tolerance.

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This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.