Larry Lindsey

President & CEO, The Lindsey Group

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Opinion

Why the Fed should consider Theory of Reflexivity when fixing policy

Jun 3

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Larry Lindsey

President & CEO, The Lindsey Group

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The Theory of Reflexivity, often used in the context of economics and financial markets, implies that investors don’t base their decisions on reality but on their perceptions of reality. This creates a feedback loop where investors’ perceptions influence economic fundamentals, which in turn alter investor perceptions.

Watch the above video as Straight Arrow News contributor Larry Lindsey explains the Theory of Reflexivity in the context of current inflation challenges and argues that Fed Chair Jerome Powell should consider it when fixing monetary policy.


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The following is an excerpt from the above video:

Well, we have a great example of reflexivity that’s going on now and that’s actually part of causing inflation. At the end of last year, Chairman Powell and other members of the Federal Reserve Board said that they were thinking about cutting rates in 2024. The markets went ecstatic. They said, “Oh, they’re going to cut them seven times.” Well, that’s probably never going to happen. But anyway, that was a strong signal of rate cuts.

Now, it was not any irrational decision. If you looked at what was happening, for example, that prints for the producer price index were coming in at 0.2% a month, which is pretty consistent with where the Fed wants to go. The CPI at the end of last year was running at just 1.9%, which was at the Fed’s target. So Powell said, “Oh, we’re going to cut rates.” Well guess what happened immediately thereafter, literally, starting in January, when he sent the signal in November and December? Inflation soared. The producer price index every month went from .2% to .4%. The consumer price index went from 1.9% at the end of last year to 4.4% in the first four months of this year. That’s quite a change.

Now, did the Fed simply saying something, did that cause the inflation? Well, here you go back to the question of what is causal. Someone just saying something doesn’t cause inflation. But as in reflexivity, it causes other reactions and the cause and effect gets mixed up.

Today I’d like to introduce what’s probably a new term to most people. It’s called reflexivity. It’s a term used in markets. It was actually George Soros who popularized the use of it. What is reflexivity? It’s a study of circular relationships cause and effect, particularly psychological ones. So you may see an event that would cause something to go one way. But sometimes when it goes that way, it creates pushback that leads things the other way. That is reflexivity? Well, we have a great example of reflexivity that’s going on now. And that’s actually part of causing inflation. At the end of last year, Chairman Powell and other members of the Federal Reserve Board said that they were thinking about cutting rates in 2024. The markets went ecstatic. They said, Oh, they’re going to cut them seven times, well, that’s probably never going to happen. But anyway, that was a strong signal of rate cuts. Now, it was not an irrational decision. If you looked at what was happening, for example, that prints for the Producer Price Index, we’re coming in at two tenths of a percent a month, which is pretty consistent with where the Fed wants to go. The CPI, the end of last year was running at just 1.9%, which was at the Feds target. So Powell said, Oh, we’re going to cut rates. Well guess what happened immediately thereafter, literally, starting in January, when he sent the signal in November and December, inflation soared. The producer price index every month went from point two to point four, the Consumer Price Index went from 1.9% at the end of last year to 4.4% in the first four months of this year. That’s quite a change. Now, did the Fed simply saying something did that cause the inflation? Well, here you go back to the question of what is causal. Someone just saying something doesn’t cause inflation. But as in reflexivity, it causes other reactions and the cause and effect gets mixed up. For example, you’re a businessman. Do you want to raise prices? Oh, yes, you do. You always want to raise prices if you can. The problem is you may not be able to. At the end of last year, when the Fed had been acting tough all along, were not going to cut rates until inflation is solidly down. The businessman got a little bit worried, because if he tried to raise rates, it might not go through because the economy wasn’t there to support the higher prices. Well, now Powell remove that threat, the Fed isn’t going to be a meanie and take away the economy. So go ahead, raise your prices. I’m sorry, you’re gonna have the money still being printed now to support them. And so more price increases went through. And the same thing is true on the demand side. stock market and housing prices began to soar. For example, the stock market in a mere six months from Halloween until April Fool’s Day went up 27%. That’s a lot of money. People were about $11 trillion richer. On April Fool’s Day, they had been on Halloween. All thanks to a market that was responding to pals promise of cutting rates. Well, if you’re that much more rich, and you’ve got 11 trillion more dollars, you’re probably going to be less frugal, you’re going to spend more and what we call the personal saving rate went down. So people are out there spending their newfound wealth. And businessmen are figuring out that gee, the Fed isn’t going to be a meanie, so maybe I can get ahead with my price increases, push them through, they’re not going to be pushed back. And that’s what happened. That’s reflexivity. Again, the Fed didn’t necessarily cause the acceleration of inflation. But the cause and effect was such that it caused other people to say, Hey, let’s go for it. And that pushed inflation back up. When Soros introduced the notion of reflexivity, it was as a caution to policymakers. Be careful things are are not as simple as they look. And this is what just happened to the Fed. Rather than look in the rearview mirror at the numbers that are just coming in on something like inflation, the Fed might better be better off looking at some forward looking indicators, such as the stock market. If the stock market is booming, well, that means there’s going to be more demand. That means businessmen are optimistic, and maybe you shouldn’t give it any more encouragement. On the other hand, if the stock market is falling, even if the economy is doing well, you might want to think about cutting some rates. That’s going to require a change in behavior by the Fed. But if the Fed is going to use financial markets, it should do so bearing in mind that everything in the financial world is governed by the laws of reflexivity. This is Larry Lindsey for straight arrow News.

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