I was confused and disheartened by the Fed's announcement that it would not be commencing the expected tapering of QE. Noting the appearance of the word "fiscal" in the announcement, I searched among speeches, testimony and press releases at the Fed's website for material that might clarify its concerns about fiscal policy.
There is ample support for the view that some Fed members, and perhaps a majority, are fearful that a bull in the china shop approach to fiscal sustainability will endanger the fragile financial recovery. It should be born in mind that these people do not operate in a vacuum, and their connections may give them insight into the possibility of productive compromise coming out of the budget negotiations.
A $20 billion cut in QE would have been more or less a symbolic move. But it was not done, because the Fed members do not wish to deliver the first blow in a one-two knockout. Under the circumstances, prudence suggests a review of investment positions, with the idea of reducing vulnerability to a sudden sell-off precipitated by political stupidity and confrontational grandstanding.
From a speech entitled "Fiscal Sustainability," delivered by Ben Bernanke on June 14, 2011:
Perhaps the most important thing for people to understand about the federal budget is that maintaining the status quo is not an option. Creditors will not lend to a government whose debt, relative to national income, is rising without limit; so, one way or the other, fiscal adjustments sufficient to stabilize the federal budget must occur at some point. These adjustments could take place through a careful and deliberative process that weighs priorities and gives individuals and firms adequate time to adjust to changes in government programs and tax policies. Or the needed fiscal adjustments could come as a rapid and much more painful response to a looming or actual fiscal crisis in an environment of rising interest rates, collapsing confidence and asset values, and a slowing economy. The choice is ours to make. (emphasis added)
Fiscal sustainability is a long-run concept. Achieving fiscal sustainability, therefore, requires a long-run plan, one that reduces deficits over an extended period and that, to the fullest extent possible, is credible, practical, and enforceable. In current circumstances, an advantage of taking a longer-term perspective in forming concrete plans for fiscal consolidation is that policymakers can avoid a sudden fiscal contraction that might put the still-fragile recovery at risk. At the same time, acting now to put in place a credible plan for reducing future deficits would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence. (emphasis added)
While it is crucial to have a federal budget that is sustainable, our fiscal policies should also reflect the nation's priorities by providing the conditions to support ongoing gains in living standards and by striving to be fair both to current and future generations. In addressing our long-term fiscal challenges, we should reform the government's tax policies and spending priorities so that they not only reduce the deficit, but also enhance the long-term growth potential of our economy--for example, by increasing incentives to work and to save, by encouraging investment in the skills of our workforce, by stimulating private capital formation, by promoting research and development, and by providing necessary public infrastructure. We cannot reasonably expect to grow our way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face. (emphasis added)
The quoted material is calm, logical and carefully thought out. It outlines what the Fed needs to see in order to conduct monetary policy in a way that is coordinated with fiscal policy and can ultimately result in taking its balance sheet down to pre-recession levels.
There is presently no evidence that fiscal policy will be conducted so as to increase incentives to work and to save, or for that matter, to invest. Jack Kemp is rolling over in his grave. There is a very real prospect that a sudden fiscal contraction might put the still-fragile recovery at risk, resulting in collapsing confidence and asset values.
Let's take a look at the minutes of the FOMC's October 23-24, 2012 meeting:
In 2014, economic activity was projected to accelerate gradually, supported by a lessening in fiscal policy restraint, gains in consumer and business confidence, further improvements in financial conditions and credit availability, and accommodative monetary policy. (emphasis added)
However, many participants saw the uncertainty attending the unresolved U.S. fiscal situation and the ongoing fiscal and financial strains in the euro area as factors likely to restrain the pace of economic growth in coming months. (emphasis added)
Some participants noted that the outlook for business spending would likely be difficult to assess until the direction of U.S. fiscal policy becomes clearer. A few suggested the possibility that a near-term resolution of the fiscal situation might lead to a significant increase in spending as projects now being deferred were undertaken; another worried that the uncertainty attending the outlook for fiscal policy might weigh on business planning for some time. (emphasis added)
The Fed's inaction on tapering is driven by concerns about the present and future conduct of fiscal policy. These people talk to each other, and to politicians. At a minimum, they don't want the Fed to be perceived as exacerbating problems created by excessive fiscal consolidation. In a worst-case scenario, they want the Fed to have clean hands when Congress administers the coup de grace to the still-fragile recovery.
Fiscal and monetary policy need to be coordinated. Monetary policy is a relatively blunt tool. Pouring money into the coffers of the TBTF banks doesn't create jobs. The trickle down from asset inflation is slow, very slow. Fiscal policy can operate with laser precision, at least on a comparative basis. Something has to be done about skills, incentives and infrastructure. There are those who complain incessantly about uncertainty. Let them contribute to reducing it by cooperating and compromising on fiscal policy.
From current market levels, any meaningful diminution of economic activity will result in a decrease of asset values. I would avoid owning anything under the belief that a greater fool will come along.
There are companies with solid business models and strong balance sheets. Many of them are better run than the U.S. Government. There is no need to relinquish control of these valuable assets.
It's always prudent to maintain a cash reserve. Now would be a very good time to review one's position, and make sure that there will be no pressure to sell valuable assets into a down market. Also, now would be a good time to think carefully about how much dry powder would be desirable in the event of a market sell-off.
Additional disclosure: I'm long US equities, with substantial cash reserves and defensive positioning.