The Fed crossing the River Styx to normalcy

The markets have weathered Phase I adjustments of Fed policy with the end of QE. The market overhang of the taper is gone because the job has been completed, but we now trying to move into the new phase of the monetary cycle or adjustment to normalcy. Although at this time, it seems as though the Fed may stay in limbo and not able to cross-over to Phase II.  There seems to be a endless sets of reason for why a little more time is needed before we start the journey to normalcy. Just a little more time for condition to be just right. The market has not fully paid its toll, so the Fed cannot cross over the River Styx to the path of normalcy and the fed will not start the journey until ti believes the economic waters are perfectly calm.

Now what is the toll for normalcy? It could be an adjustment in prices to reflect less leverage in asset markets. A return to monetary normalcy means a return to more rational credit markets where cheap money no longer hides unsound business and speculation. The toll seems to be an adjustment in equity markets regardless of what is happening in China. The toll is being paid, but that also means the economic waters will not be calm. Conditions for crossing to normalcy will never be perfect.

What happens when we get to the other side of the river? If we had to articulate the process and impact of Phase II monetary policy, the answer is that it would not be easy to manage or explain. Just saying that there will be a normalization of rates when the Fed is sitting on a large balance sheet is too simplistic. The adjustments in rates will not be through the Fed funds market but through reverse repo. The simple reduction in excess reserves will not be the process for raising rates. There will be a high level of uncertainty on what will happen when normalcy begins. 

We cannot say that the present sell-off is associated with this uncertainty, but we can say that as more investors focus on Fed mechanics, there will be more volatility and uncertainty on what will happen in the biggest and most complex funding market in the world.