A lot has been written lately about the unprecedented nature of Fed monetary policy on markets. Many economic experts are debating the pros and cons of these policies. We wonder aloud whether the titanic proportions of Fed policies are modestly helpful for the economy in the short term but are providing a false sense of security against dangers lurking below the surface.
Let's begin with a review of the economic impacts of Chairman Ben Bernanke’s quantitative easing or "money printing" policies. Wikipedia defines quantitative easing (QE) as "an unconventional monetary policy used by some central banks to stimulate their economy when conventional monetary policy has become ineffective. The central bank buys government bonds and other financial assets, with new money that the bank creates electronically, in order to increase money supply and the excess reserves of the banking system." Quantitative easing also inflates prices of financial and other assets as the excess liquidity created by the Fed needs to find a home. This phenomenon lowers the expected future return/yield of financial and other assets. Take for example short term U.S. treasuries where the Fed has targeted their QE purchases. The distribution yield on iShares 1-3 year Treasury ETF (SHY) is 0.96%. This compares to the Consumer Price Index (CPI) for March 2011 of 2.7% and Core CPI (excluding food and energy) of 1.2%. This loss in purchasing power is the "injustice inflicted on savers" referenced by Dallas Fed Governor Richard Fisher last month. Note that the injustice is far more tolerable if miraculously you do not require food or energy for your daily existence!
The initial $1.7 trillion of quantitative easing, or QE1, was designed to buy mortgage backed securities to bring liquidity back to that market place. QE2 initiated last fall enabled the purchase of a further $600 billion in U.S treasury securities to prevent a double dip recession. On top of this the Treasury advanced $700 billion through the Troubled Asset Relief Program (TARP) to recapitalize the major banks. All three of these programs were viewed as wildly successful in the eyes of its architects but in reality are "not worth the paper the trillions of digital dollars were not printed on" to quote Gerald Celente of Trends Journal. The housing market is still in shambles, a technical double dip recession has been avoided in lieu of confiscatory monetary policy, and zombie banks hide their loan losses through weak accounting practices condoned by bank regulators.
Meanwhile, the Federal Reserve balance sheet has grown from a pre-crash $800 billion to $2.8 trillion. Normally this would be highly inflationary, but it has not been this time because all of the extra money is being held as excess reserves at the zombie banks. Inflation is also being exported to our trading partners in China, the Middle East and other suppliers in the rest of the developing world that peg their currencies to the dollar. These trading partners don't let their currencies appreciate against the dollar by printing money themselves which brings on inflation in their own economies. According to Hussman Funds, the U.S. monetary base will soon reach a new historical high relative to GDP of about 17 cents for each dollar of GDP at the end of QE2. This compares to the previous high of 15 cents which occurred at the peak of the 2008 financial crisis as everyone rushed to the safety of cash and waited for the deflationary impacts to lower prices for goods and services and assets of all types.
The challenge for the Fed going forward is for it to skillfully unwind its balance sheet at the same rate that the banks begin paring back excess reserves through more lending. If the Fed adjusts its balance sheet too slowly, it risks inflation. If the Fed moves too quickly, it risks falling back into recession. The Fed has recently signaled that at the end of QE2 it is likely to maintain a neutral stance by only reinvesting principal and interest payments received on its mortgage and treasury investments into new securities purchases. In other words, the Fed will maintain the monetary base near its current size. If the zombie banks don't increase lending with Fed money creation on hold, the logical outcome is for the economy and markets to stagnate.
Although these quantitative easing policies have been highly effective at causing asset price inflation and the appearance of a sound economy, recent global stock and commodity sell-offs suggest investors have started to discount the reality of a weakening U.S. and global economy. For example, decline in the CRB commodity index of over 6% in the first week of May represented the fifth deepest weekly plunge in the last forty years, rivaling the declines posted during the 2008 market meltdown (when the monetary base last peaked) and exceeding the deflationary plunges posted in 1975 and 1980.
This could be the beginning of a market corrective phase given the high correlation (something like 0.88) of the advances in all asset classes, particularly equities and commodities, with Fed increases in the monetary base. Investor worries seemingly began when the initial report of first quarter 2011 GDP came in at 1.8% down considerably from fourth quarter 2010 GDP of 3.1% and well below economists' consensus. This was followed by weekly jobless claims taking a turn for the worse and a poor showing for a leading indicator for the all important U.S. service sector when the non-manufacturing Institute for Supply Management (ISM) index dropped 4.5 percentage points to 53.7%. In addition to the completion of QE2, the end of many of Obama's stimulus programs are just around the corner. Factor in the deflationary impact of $4 to $5 gasoline (non-core CPI item) on discretionary spending and that suggests significant headwinds for the U.S economy by the beginning of 2012. Meanwhile global central banks have been moving aggressively to tighten monetary policy to counter inflationary pressures. The first week of May alone saw the Reserve Bank of India, State Bank of Vietnam, the Philippine and Malaysia central banks raise their short-term interest rates.
By definition we know that 1) conventional monetary policy has become ineffective and 2) quantitative easing is intended to stimulate the economy. With the economy seemingly sputtering, some investors have begun to conclude that despite Chairman Bernanke's self congratulatory demeanor, his unconventional monetary policy has largely been ineffective in stimulating the economy. The quandary for the Fed and market participants is what can the real economy do on its own? This creates uncertainty and market volatility. With Fed monetary policy already at extremes and an election cycle underway the greatest national risk is that Chairman Bernanke and his crony Fed governors believe more unconventional monetary policy is necessary and continue pushing modern economic policy to new limits.
One financial analyst likened the riskiness of current Fed monetary policy to Chairman Bernanke doing a high wire act in high winds with no safety net. Unfortunately there are more stakeholders involved in Ben's high wire act, and it is far more appropriate to think of Bernanke as the captain of the cruise ship America charging through uncharted, dangerous, and bone-chilling waters with all of us aboard.
"I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern ship building has gone beyond that."
-Captain Smith, Commander of Titanic
All is not well, but rest assured that policymakers are busily rearranging the deck chairs. With each additional policy action, Captain Bernanke will leverage the media (60 Minutes, Washington Post and press conferences) to assuage passengers that the ship is sound, the path is clear and unassailable, and his infallible hand is firmly at the helm.
Our recommendation is that you steer your portfolios to safer waters and make your long term investment journey more enjoyable.
Bon voyage.
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