Easy Money (3) - Fed Ignores Those Harmed by Policy

 |  Includes: CPI, DIA, EEM, FXF, GLD, JNK, OIL, SPY, UUP
by: John Tobey, CFA

With all the talk about the Fed's easy money actions, there remains one subject that is largely ignored: Who's paying for the Fed's largess?

With low interest rates, lots of money and good intentions (increase employment and bolster the economy), the Fed's easy money policy seems like a win-win situation. The only "cost" appears to be inflation – and that, the Fed assures us, is low.

However, the Fed has remained silent about the all those who have been harmed by the Fed's easy money policy.

Low interest rates – think price fixing

The Fed's low interest rate policy is the same as price fixing. Left to normal market functioning, short-term interest rates would be higher now – perhaps around 2%. Instead, the Fed is keeping them near zero. These abnormally low rates, like low fixed prices, certainly benefit "buyers" who get more. In turn, however, they harm "sellers" who receive less.

In the case of low interest rates, those "sellers" are individuals (think savers and retirees) and institutions (think pension funds and corporations) with money market holdings. For 2-1/2 years, they have seen their savings' purchasing power steadily eroded. In the last write-up, "Fed Policy Understates Money Growth", we discussed how the Fed's near-zero interest rate policy has driven enormous sums out of safe, short-term holdings into riskier, longer-term securities in the search for income.

But the Fed ignores those adversely affected by its policies. In fact, it has a strategy of focusing only on the positives.

The Fed's one-sided messages

The Wall Street Journal yesterday (Monday, April 25) is filled with Federal Reserve related articles. Included is the Fed's biased view of their easy money policy, namely:

Message #1: The Fed's low-cost money supports the economy and employment

There is a long-time Fed analogy that disproves this proposition. A Fed tightening is like "pulling a noose" – very effective at cutting off economic growth. However, a Fed loosening is like "pushing on a string" – it requires businesses and consumers to take up the slack in order to achieve any benefit.

The danger is in pushing too much money into the system. When money exceeds the amount needed within the economy, it can flow into potentially harmful speculation – like what we are seeing in commodities (a form of inflation).

Message #2: The Fed is on the lookout for inflation, but doesn't see any

As we discussed earlier in "U.S. Inflation Now at 4% - How Fed Dismisses the Signs", there are signs of inflation, but the Fed chooses not to discuss them. Rather, Fed officials point to selected price indexes as proof that inflation is low.

Moreover, those officials say there is no increase in inflation expectations. This statement is suspect for two reasons. First, bond vigilantes (investment managers) have bid up longer-term bond yields, something they do when they see inflation risk rising. Second, consumer expectations of future inflation have been rising. The Fed has taken the stance that those expectations are temporary and, thus, can be ignored.

Message #3: The Fed-induced decline in the U.S. dollar is good for the U.S. economy because it makes exports more competitive (cheaper)

This is a remarkable "glass is partially full" view of a negative situation. When we see the dollar falling, we need to worry, not rejoice, because:

Imports are more expensive – The U.S. runs a significant trade deficit, meaning imports exceed exports. Therefore, any decline in the dollar produces higher import prices. Over the past 12 months, here's what happened to trade prices (March 2010 to March 2011):

  • U.S. dollar exchange rate with major trading partners = -5.8% (decline)
  • Import Price Index = +8.5%
  • Export Price Index = +8.3%

Commodities are priced in the world, not the U.S. – While we think in terms of dollars, worldwide commodity prices (think oil) are based on global demand/supply. Therefore, as the U.S. dollar falls, commodity prices in the U.S. necessarily rise in dollar terms even if they are stable elsewhere.

Here's what happened to gold over the past 12 months (through April 15). Note that the higher the return, the more the currency's exchange rate fell – the U.S. dollar fell the most, so gold "rose" the most in the U.S.

Gold price change in different currencies:

  • U.S. dollar = +28%
  • Canada dollar = +23%
  • UK pound = +22%
  • Euro = +20%
  • Yen = +14%
  • Swiss Franc = +8%

The U.S. is a borrowing nation – The sizeable U.S. trade deficit and the U.S. government's deficit/borrowing mean trading partners and foreign investors are needed to hold dollars and U.S. dollar bonds. As the dollar declines, those foreign positions produce lower or negative returns, making such holdings less desirable.

Message #4: The Fed's actions have spurred a rise in the U.S. equity markets

Bernanke's taking credit for the stock market's rise is incorrect. The market is up because company earnings have increased – not because the Fed spurred investor flows. In fact, stocks have lagged the increases in estimated earnings.

Dow Jones Industrial Average (DJIA) – past 12 months

  • April 2010: Estimated EPS for 2010 = $795
  • April 2010: DJIA = 11,204
  • April 2011: Estimated EPS for 2011 = $986 (+24%)
  • April 2011: DJIA = 12,506 (+12%)

Rather, investors have been busy buying bonds, commodities and foreign securities, including high-risk securities such as junk bonds and emerging market stocks.

Other 12-month returns through April 21:

  • PowerShares DB U.S. Dollar Index Bullish (NYSEARCA:UUP) = -10.7% (decline)
  • iPath S&P GSCI Crude Oil TR Index ETN (NYSEARCA:OIL) = +11.3%
  • SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK) = +12.3%
  • iShares MSCI Emerging Markets Index (NYSEARCA:EEM) = +18.6%
  • CurrencyShares Swiss Franc Trust (NYSEARCA:FXF) = +20.4%
  • SPDR Gold Shares (NYSEARCA:GLD) = +30.7%

The irony: Fed's easy money policy is making people uneasy

The latest Gallup poll shows the public confidence in Bernanke is at a new low. Fully 40% say they have "little or no" confidence in him, equaling those who say they have a "great deal or fair" amount. Because confidence in the future is based on confidence in the present, this is not a good sign.

A key point to remember: The Fed's next step is not to tighten; it is to stop loosening

When the Fed finally stops buying bonds and, especially, allows the market to set short-term interest rates, that will be a move back to normal. Their current easy money policy is abnormal – meaning their actions are out of the ordinary. "Tightening" is the raising of rates to an abnormally high level - and we are a long way from that happening.

The key question: When will the Fed stop loosening?

Although some Federal Reserve leaders have voiced concerns about continuing the easy money policy, the Federal Open Market Committee's (FOMC's) three leaders (Bernanke, Yellen and Dudley) claim to see no problems.

Therefore, in spite of the facts and warnings that many have expressed, the FOMC may not step away yet.

A final thought: Public discourse might be a disadvantage

Wall Street hates uncertainty, so it has been a major force in getting the Fed to open up. It used to be that FOMC discussions were kept secret for some time, and Fed officials rarely divulged their current thinking.

The rationale was that they didn't want their actions to be offset (like Bill Gross' shorting of U.S. Treasury bonds while the Fed is buying) and they wanted to remain flexible. This latter point is important – it means they wanted to be able to alter a policy in light of current, especially unexpected, developments.

Ben Bernanke is moving significantly away from that previous process by ramping up the public discussion – even including Jon Stewart and Wednesday's press conference. The serious drawback is that the strong, public comments have made Bernanke, Yellen and Dudley intransigent – unable to make needed position changes without creating disturbances and undermining their own personal standings.

So… problems continue to arise from the Fed's lengthy easy money policy. The growing number of adverse observations have so far not altered the FOMC's position.

When the FOMC's (Bernanke's) publicly discloses of its position on Wednesday, what shall we do as investors? This is the subject of the next write-up: "Easy Money (4) - Investment Steps We Can Take.”

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Client positions: Long U.S. stocks and U.S. stock funds