Free Markets Are Not Designed to Be on Railroad Tracks

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The mechanical devices that direct trains from one rail to another are known as railroad switches. Their shape is tapered to make the transition to a new set of rails smooth and, more importantly, to prevent the train from jumping off the rails completely.

Accompanying a switch is a point indicator, essentially a street sign to inform train conductors which direction the switch will take them. It tells them if the train will continue straight or turn.

There are several parallels between railway logistics and monetary policy today, and one big difference.

"Policymakers have robbed the future to benefit today—or perhaps more accurately, they have robbed today to benefit yesterday."

Monetary policy has been to asset prices what railroad tracks are to trains—taking prices wherever they may lead. The markets have not had the freedom to find their own direction, but have been steered by the very visible two rails of asset purchases and forward rate guidance. Because prices are being steered, they have discounted the risk that their direction could go any way other than the path directed by the Federal Reserve. It is a fundamental necessity for the proper functioning of pricing mechanisms that they take into account downside risk.

The discounting of that risk along with an associated euphoria are the root causes of price bubbles. From tulips to tech stocks to housing, one common theme between the most disastrous price bubbles in modern history has been a euphoric belief that prices will rise forever and that the risks are irrelevant. When those bubbles deflate, they take from an economy everything that they gave it during their inflation, a process which is already beginning to unfold in the U.S. economy.

It is one more way that policymakers have robbed the future to benefit today—or perhaps more accurately, they have robbed today to benefit yesterday.

Like a train approaching a railroad switch, the markets are now approaching a switch in Fed policy. The Fed wants to ease the markets back to a place where they set their own prices without the manipulation of quantitative easing (asset purchases). Much like the railroad switch is tapered to make for a smooth transition, the Fed plans to taper their purchases hoping for the same effect. To make sure the markets are prepared for the switch, the Fed has provided point indicators in the form of forward guidance as warning signs.

Free markets, however, are not designed to be on railroad tracks no matter how smoothly the switches are tapered. Nor do they wait for point indicators to tell them which way the switch will direct them. Rather, participants in free markets invest in making better binoculars than their competitors so they can see which way the track is going in the distant future. When they think they know, they jump off the rails hoping to be the first ones to the new course.

There is a saying on Wall Street: "Don't fight the Fed." Experience shows that investors who bet against the Fed ultimately lose. If the Fed wants yields to drop, they will likely accomplish their objective. If they want yields to rise, they will likely accomplish their objective.

As a result, their policy decisions elicit a binary response – investors either buy or sell. This has been evident in the big price swings in assets across the globe this year. It is this reality which will necessarily make the transition to new tracks anything but smooth.

In response to volatile markets, the Fed will likely be forced to continuously modify their switch. Most likely, they will be compelled to reduce their asset purchases more slowly in hopes of keeping an interest rate shock from quelling the nascent rebound in housing and consumer confidence. If they do, the markets will jump from their rails again.

While a change in the plans will necessarily create volatility, the real issue is that the markets have to get back to setting their own course. Like many things in today's policy world, Washington has chosen to give the markets a ride to their destination rather than letting them find their own way.

Unless the U.S. wants to abandon free markets, the Fed has to quit laying track at some point. More importantly, they need to quit laying tracks because only then will the risks of excessive debt, bad fiscal policies, unfundable future promises, regulatory overreach, and convoluted tax rules be evident.

A change of course is at hand. It is a new world in which volatility will be present. It is a new world in which investors must be brave.

—Craig Dismuke is chief economic strategist at Vining Sparks.