The Fed's Doubting Thomas (Hoenig)

Includes: BAC, C, GE, JPM, MS
by: Bernard Thomas

The FOMC announced its rate decision on Tuesday, and anyone who was surprised by the Fed's decision to leave the Fed Funds rate effectively at 0.00% (actually 0.00% to .25%) is either delusional or living under a rock.

The Fed did give us a mild surprise by deciding to reinvest the proceeds of its maturing mortgage-backed securities into U.S. treasuries (especially longer-dated treasuries). Aside from helping to keep long-term rates in check, the impact on improving economic growth is negligible.

Here is the Fed's statement:

"Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee's ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve's holdings of longer-term securities at their current level was required to support a return to the Committee's policy objectives."

None of what the Fed published in its statement is novel. Recent economic data indicated everything the Fed stated. Businesses have little need to add to staffing. Whenever possible, businesses will choose to spend on productivity rather than workers. Bank lending is contracting, due in good part to a reduced demand for credit as stimulus plans have ended and overleveraged consumers cannot and will not add to already high debt levels. Some investors where hoping that the Fed would see a silver lining inside the economic cloud. All it found was rain, not a recessionary torrent mind you, but a growth dampening drizzle.

Interestingly, one voting member dissented. That person was Kansas City Fed president Thomas Hoenig. Mr. Hoenig is of the opinion that the Fed buying long-dated treasuries and stating that it will keep the Fed Funds rate low for an extended period of time will help speed the economic recovery. Some have interpreted his opinion to mean that the economy is in fact on the path to robust growth.

Although I disagree with the optimistic interpretation of Mr. Hoenig's dissent, I do agree with his opinion. The Fed has already done everything it can do to foster an economic recovery. In fact, the Fed may have set itself and the country up for future inflationary or stagflationary problems, unless Mr. Bernanke or his eventual successor takes a page out of Paul Volcker's book (Note: Although possible, I do not believe that neither inflation nor stagflation are a near-term possibility as we are not the only large economy facing a recovery with head winds - see Europe.

No, I believe Mr. Hoenig sees the situation for what it is. The U.S. economy was over-stimulated for over two decades which led to rates of consumption and increases in asset values, such as home prices, to rise to levels which were beyond their structurally possible potential. Now we all have to come back to earth. 2.00% to 3.00% GDP may be all we get.

We are not entitled to a new SUV every few years or a 4,000-square-foot McMansion. An economy predicated on ever stronger sales of SUVs and continued home building is fundamentally unsound. The amount of cars which can be sold and the amount of homes which can be built is finite. There is only so much land and, unless we see large waves of immigrants, population growth may be slowing. Much like trying to fight the last war, trying to recreate the economy of the past 20 years may be an exercise in futility, much like pushing on a string.

Stay away from LIBOR and CPI floaters, buy TIPS which trade near or below par and have inflation indexes as close to 1.0 as possible (if not below) and then only has a hedge. A better hedge would be a step-up note and please; ladder, ladder, ladder.

Tip of the day: Bond features such as calls floating rates and step coupons tend to favor the issuer in most scenarios, not the investor.

Disclosure: No positions