Fed over-steering, 2008 through 2014

The Federal Reserve Open Market Committee (FOMC) and Fed Chair Janet Yellen recently released two statements which reiterated their "overall commitment to maintain extraordinary support for the recovery for some time to come."  While financial markets rallied on each of these statements, we believe that the Fed has really run out of options in terms of "supporting recoveries" and what's more, we believe that efforts by the Fed to steer the economy almost always end up doing more harm than good.  However, since investors cannot control the Fed and their attempts to steer the economy, they should instead focus on selecting investments that are least threatened by the damage which the Fed's steering is likely to cause.

The first recent statement was released by the FOMC at their regularly-scheduled March 19th meeting (text here) and the second was a speech by Janet Yellen on March 31st (text here).  To understand them, investors should know that the Fed is using two tools to add extraordinary stimulus to the economy, which it has been using since the economic crisis of 2008 and 2009.  Those two tools are:

  •  an extraordinarily low fed funds rate which targets the interest rate for the shortest borrowing periods (targeting 0% to 0.25%, the lowest fed funds rate ever, a target which has been in place since late 2008), and . . .
  • a policy of buying Treasury and agency debt (agency debt refers primarily to mortgage-backed securities packaged up by government-sponsored "agencies" such as Fannie Mae and Freddie Mac) in order to artificially increase the demand for that debt and thereby artificially depress the interest rates on such debt instruments (if demand for agency debt or Treasury debt falls, then those agencies must raise the rates on that debt in order to sell them, but if demand for them is artificially boosted then those rates can be lower and the debt can still find a buyer -- because the Fed has become a huge buyer).  This second policy is called "quantitative easing" (or "QE") and the chart above shows the debt purchased by the Fed, which becomes an asset on the Fed's balance sheet, with the growth in Fed assets labeled for QE 1, QE 2, and the current QE 3.
In the two statements mentioned above, the FOMC and Janet Yellen basically declared that the Fed will continue both of the above policies until the Fed determines that the "outlook for the labor market has improved substantially" (the statements also use the term "maximum employment").  However, the Fed has been slowing the rate at which they are buying agency debt, and the rate at which they are buying Treasury debt.  They also said that at some point after they wind up their quantitative easing, the Fed will begin to "remove policy accommodation," that is to say "raise the target fed funds rate" again from its current unprecedented low level.  They do not say anything about "unwinding" the Fed's balance sheet -- that is to say, reducing the huge bulge of assets that they have accumulated under QE 1, QE 2, and QE 3 shown in the chart above (now well over $4 trillion of assets, primarily Treasury and agency debt).

While the Fed's statements argue that these policies are designed "to encourage consumers to spend and businesses to invest, to promote a recovery in the housing market, and to put more people to work," and while Janet Yellen's March 31st speech declares that "There is little doubt that without these actions, the recession and slow recovery would have been far worse," we disagree with both of these assertions. We have long argued that the Fed should focus on price stability, and stop trying to "steer the economy" -- see for example "The Fed's oversteering and the wreckage of the past decade" (07/23/2009); "Why do we want the Fed to steer the economy" (09/01/2010); and "Likelihood of Fed over-steering increases" (01/25/2011).  When the Fed tries to steer the economy, history shows that they almost always over-steer and cause a tailspin of some sort.

We also believe that the Fed has probably run out of options for steering the economy, as a direct result of the enormous asset purchases.  Economist Brian Wesbury has pointed it out in an important new commentary entitled "Repudiating Milton Friedman" (dated 03/31/2014). With all those excess reserves, Brian Wesbury explains in his analysis, the Fed can try to raise the fed funds rate all it wants, but that won't stop the banks from deciding to use their excess reserves to make loans and thus to increase the supply of money into the system.  And that, he explains, could lead to the runaway inflation that many pundits have long predicted from these excess reserves, but which has not materialized thus far.  This is because the Fed had previously said those excess reserves would be temporary, and because the artificially low interest-rate environment made lending less attractive.  If the Fed is now signalling that it will someday raise rates without unwinding those excess reserves, then all bets are off and the M2 money supply could finally expand at a very rapid pace.

This is why Brian called his piece "Repudiating Milton Friedman," because Milton Friedman famously said that inflation is always caused by too much money chasing too few goods.  If the scenario described above takes place, Brian notes, the Fed may have to try to stop banks from lending by creating regulations that order them not to loan.  Such regulation would be at odds with trying to influence money supply using the old tools of supply and demand (tools which don't work very well if you leave the banks with such a swollen supply of excess reserves).  

These are serious concerns and all investors should understand the reasoning behind Brian Wesbury's analysis.  He points out that the initial flood of money entering circulation could boost stock prices well above their current levels, but that the ensuing inflation and the severe Fed counter-reaction that it will undoubtedly trigger could create a major negative shock to the economy and the markets.  It will be yet another example of the horrors of Fed over-steering.  

So, what is an investor to do?  The Fed's machinations with the money supply make it certain that over the long term, their dollars will lose purchasing power, and thus it is imperative for investors to own assets that can help counteract that long-term loss of purchasing power. The Fed's machinations also make fixed-income investing extremely hazardous for the foreseeable future, in our opinion -- something we discuss in a previous post entitled "The crisis facing fixed-income investors."  

Ultimately, we believe investors are best served through the ownership of assets, including equity in well-run, growing businesses, and we believe that those equities must be selected very carefully with the above monetary-supply scenarios firmly in mind.