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I wouldn’t want Yellen’s job for all the money on the Fed’s balance sheet. She can’t win no matter what she does. Given the Federal Reserve’s mandate, Thursday’s decision to leave rates unchanged was the correct course of action. To start a tightening campaign with inflation running below target and the global economy imploding would be foolishness of the tallest order. Yet due to the ensuing stock market sell off, everyone is pissed at Yellen’s decision.

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The monetary hawks are screaming blue murder that the market is selling off because the Fed is irresponsible (which is complete horse shit, but that doesn’t stop them). The doves are scared that Yellen can no longer engineer their reliable consistent steady climb higher. Somehow they think that constant 10% positive returns are their God given right.

Everyone is a critic of the Federal Reserve. Although I am sympathetic to the complaints about the seemingly never ending zero interest rate policy, to blame Yellen is giving her way too much ability to control things.

The real mistake was committed almost twenty years ago when Greenspan recognized the dangers of the overly easy monetary policy, and instead of having the courage to tighten, merely gave a speech.

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December 5th, 1996 was probably the last time we could turn back. At that point Greenspan noted the possibility of the stock market being “irrationally exuberant.”

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On that date, credit as a percentage of GDP was roughly the same as during the 1929 boom high. Engaging in prudent economic policies would have been painful, but it might have been manageable.

But look at what happened to debt since then. It has exploded higher. Since then any slowdown in the expansion of this debt caused a severe economic downturn.

Have a look at total credit during the 2008 financial crisis.

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The mere plateauing of credit was enough to send the global economy into a monster deleveraging vicious circle.

The Federal Reserve and the other Central Bankers have been arrogantly irresponsible for the past few decades. Yet to think we can somehow now get religion is naive.

Look really carefully at the total credit to GDP chart. Think about how much debt is outstanding. Ask yourself if the world really has the stomach to reset that debt through an Austrian style deleveraging.

There is simply no way the public will sit through a credit reset. It would be unbelievably painful.

So if the system will not get cleansed through an economic contraction, what options does that leave us? You might argue that a prescription of belt tightening austerity combined with increased saving will, over time, right the situation. But that is again simply an economic pipe dream. The moment credit starts to contract, a vicious balance sheet recession engulfs the economy. With crippling debt loads, austerity has never worked.

There is really only one answer. The debt needs to be inflated away. It might not be what is “right” or “fair,” but it is what it is. Inflating away your debts is as old as the hills. To think we will somehow end up with some other solution is a fairy tale.

In the mean time, the longer Central Bankers refuse to accept this reality, the bigger the debt burden grows. They muddle through with half hearted attempts to keep the system balanced. Of course they always err on the side of ease, but foolish attempts to normalize policy, stops inflation from developing.

In a balance sheet recession, if every time inflation perks its head up you know the Central Bank will stop the credit expansion, a deflationary mindset takes root.

Although it pains me to say this, Yellen’s attempt to normalize rates was a huge policy error. She cannot normalize rates. She needs to be responsibly irresponsible. Otherwise a deflationary vicious cycle will take root. Even talking about a potential rate hike was enough to usher in a worldwide global economic downturn.

It is obviously way more complicated than that, but don’t listen to the hawks who argue the market is imploding because the Fed wasn’t hawkish enough. The market is collapsing because a contractionary cycle has already taken hold. The knee jerk rally after the FOMC pause was the result of traders buying because they hoped the pause would be enough to arrest the vicious cycle.

Once this liquidation mindset takes hold, it is extremely difficult to stop. A simple delaying of rate tightening is not going to be nearly enough. Things will get a lot worse before they get better.

Thanks for reading,

Kevin Muir

the MacroTourist