What daVinci’s Failed Experiment Can Teach Us About The Fed

As I thought about the Federal Reserve this week, I realized they are trying to replicate one of Leonardo da Vinci’s designs.

Like many inventors throughout history, da Vinci tried to design a perpetual motion machine. This kind of machine would run forever without needing an external energy source. In technical terms, its operating efficiency would be greater than one.

The designs were eloquent.

Source: Museo Galileo

Here’s a description of da Vinci’s most advanced design:

“…a device combining four circuits, each made up of three straight paths and three curved path displaced by 120 degrees. Each circuit has two spheres that move from the side of the direction of rotation towards the outer rim and from the passive side towards the center. Mounting four of these elements on the same axis results in a rotary system with a sphere falling every 30 degrees of rotation, thus producing a series of pulses which it was thought would create the necessary overbalance to generate rotation.”

Source: Museo Galileo

Perpetual motion machines don’t work because they violate the laws of physics. These laws weren’t understood when da Vinci lived, so he can be forgiven for pursuing the impossible. But the laws of physics do mean that we cannot generate energy from nothing. Or, as economists might say, there is no such thing as a free lunch.

[See also: Why The Fed (And Analysts) Are In Uncharted Territory]

How This Applies To Us

Fed policy seems to be ignoring these laws. Current policy seems to be based on the idea that printing money and holding interest rates near zero will maximize employment while inflation will be wished away.

One reason perpetual motion machines can’t work is because there are frictions in the system. The balls in da Vinci’s machine would eventually completely disappear as friction erodes its surface to nothing.

In the economy, frictions include supply chains that can’t keep up demand or workers who gain power as an economic expansion continues. These obvious frictions generate inflationary pressures as they reduce the efficiency of the economy.

The Fed is maintaining its “easy money” policies as unemployment drops below its long-term average.

Last week’s unemployment report showed unemployment fell to 5.4% in July. This is below the 50-year moving average of 6.27% and below the 10-year moving average of 5.92%. While unemployment was low before the pandemic-induced recession, the benchmark should be the long-term average rather than 50-year lows. Using the correct comparison, we see that the economic recovery is better than average and the Fed should consider tightening its policy soon.

Unfortunately, the Fed is unlikely to reverse course quickly. There is abundant political pressure to maintain low rates so that Congress can borrow as much money as it wants to spend. And the Fed is not immune to politics. Fed Chair Jerome Powell’s term ends in February, and it’s likely a second term depends on an accommodative monetary policy.

Over the centuries, many inventors have claimed to develop perpetual motion machines. But in time, the laws of physics caught up to them. In a similar way, the Fed is trying to create perpetual gains in the economy with its policies… but in time, the laws of economics will catch up with them too.

That’s a long-term worry. In the short run, we focus on our indicators.

My Income Trader Volatility (ITV) indicator remains bullish, as shown in the bottom panel of the SPDR S&P 500 ETF (NYSE: SPY) chart below.

My ITV indicator is similar to VIX in that it rises as prices fall. Its current position, with the ITV indicator (red) just below its moving average (blue), points to potential strength in stocks.

Our last chart this week shows my Profit Amplifier Momentum (PAM), which is also bullish.

PAM is designed as a short-term indicator. The red bars are bearish, and the green bars are bullish. Its recent uptrend (marked by the change from red bars to green) is a potential indicator of strength.

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