Economic Risks And The Fed's Next Steps

by: Evan Schnidman

Over the last few weeks markets have been presented with myriad new data about the state of the economy. The Dow is at an all-time high, the unemployment rate is at its lowest level since 2008, and despite monetary stimulus the dollar remains strong in comparison to other currencies. All the while, fiscal policy coming from Washington has presented one failure after another. With the Fed's next meeting just over a week away, it is time to evaluate where Fed policy is headed.

Fed Policy Risks

Before evaluating the Fed policy timeline it is crucial to examine the risks facing Fed policy. While much has been written about the inflationary risk of asset purchases and the Fed eventually unwinding their balance sheet, a series of other risks have garnered far less attention. In particular, several of the Fed's communication strategies are risky in and of themselves. Should any of these new communications contradict a policy outcome, the Fed's credibility could be severely damaged. Nevertheless, these expanded communication measures continue.

Beyond communication, the Fed's own Beige Book data highlights the risks involved in regional differences in the rate of economic recovery. This has led to signification migration within the U.S. and helped fuel the housing market recovery. Fed Board Governor Elizabeth Duke acknowledged the Fed's role in using interest rates to fuel this housing recovery, but she did not significantly address the regional disparities in rate of recovery. Focusing on the national-level data without granting significant weight to regional differences could quickly result in a situation where the economy overheats in certain regions while still stagnating in others.

Perhaps the least obvious threat to Fed policy is the student loan bubble that the Fed has helped create. While student loans are unlike most other types of debt in that they carry over through bankruptcy and other financial proceedings, that does not mean that mass default is impossible or even unlikely. For years news sources have been running stories about the inability of college grads to get a job; this generation of underemployed workers is likely to struggle with debt repayment, increasing the likelihood of loan delinquency and default.

Future Fed Policy

Despite the risks outlined above, the Fed is likely to maintain its current policy course of ZIRP and $85 billion in asset purchases each month. While the January FOMC Meeting Minutes did acknowledge a lively debate about how and when to draw down the current asset purchases, indications are that such a policy change is still several months off. St. Louis Fed President James Bullard has even publicly stated that the Fed will continue bond purchases even as the employment picture improves. Some commentators have similarly suggested that the improved employment picture only emboldens the Fed's doves to continue the current rate of asset purchases.

Despite all of this dovish talk, the Fed's internal debate about when to "vary" or "taper" bond purchases has grown louder in recent months and investors should keep a close eye out for a tipping point when those purchases might decrease in size. Taking into account all that has happened in recent weeks, my timeline still indicates that the Fed will not draw down asset purchases until September, or at the latest, December. This gives the economy several more months of significant stimulus while a fiscal agreement can be reached, and it satisfies the growing hawkish voices that will be extremely prominent on the FOMC in 2014. Investors should ride this stimulus for a couple more months with a close eye on when the QE3 floodgates will begin to shut. Markets began their decline four months prior to the end of QE2, so if that pattern holds and my timeline is correct, investors would be wise to sell in May.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.