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Recent Federal Reserve Policy

Recent policy actions by the Federal Reserve and prevailing fundamental economic indicators paint the picture of an economy on the precipice of a liquidity trap. Policy statements over the last several weeks make it appear that the Federal Reserve is implementing the classic policy prescriptions used to combat deflationary pressures and a possible liquidity trap. In the "zero bound" interest rate environment the U.S. is currently experiencing, the last arrow in the Fed's quiver to attempt to influence aggregate demand and fight a deflationary cycle is to control inflation expectations. The Federal Reserve hopes to push real interest rates deeper into negative territory by influencing the inflation side of the real interest rate equation because nominal short term rates are constrained by zero.

Increasing inflationary expectations in the market can only be achieved if the Federal Reserve first establishes credibility that they are committed to near zero rates for a long period of time and second, establishing policy positions considered to be inflationary by the public. In late January the Federal Reserve announced that they will be regularly releasing a new report which is designed to clearly state their longer term projections for the target fed funds rate. This new level of transparency is clearly intended to establish credibility that they are committed to low rates for an extended period, in fact through 2014 based on the first report issued. In addition to establishing their intent to leave rates near zero for an extended period, in the latest policy statement the Federal Reserve also left QE3 on the table. This is a very telling development and is designed to show the market that they are willing to risk higher levels of inflation to stimulate economic growth.

As GDP has exhibited positive growth recently and with the stock market steadily moving upward it does appear that investors are being complacent to some of the deeper issues in the economy. The Federal Reserve,s actions seem to indicate they do see weakness and are currently concerned about fundamentals that present the danger of entering a liquidity trap. Examining current economic indicators and adding historical context may help uncover what the Fed is seeing and further establish where the U.S. may be in the recovery from the great recession.

Historical Perspective and Current U.S. Indicators

At the risk of being predictable, the most relevant historical perspective to current U.S. economic conditions comes from Japan's economic issues, and is a great example of what a liquidity trap looks like in a developed economy. The Nikkei peaked at the end of 1989 after a decade of robust economic growth. Japan began having problems in the early nineties and was caught in a liquidity trap that led to a deflationary death spiral from which Japan's economy to this day has not recovered. This discussion is going to skip the details as there have been numerous studies on Japan if you want more information; but to make a long story short, at the end of 1989 the Nikkei was near 39,000 today it is close to 9,000. At no point in the last 22 years has the Nikkei come close to revisiting the highs of the late 1980's.

Many argue Japan entered the liquidity trap and deflationary cycle as a result of secular change in work force demographics resulting from an aging population and both low birthrates and immigration levels. It can be argued that as America has changed to essentially an entirely service based economy while simultaneously increasing productivity, we are going through a secular change that has made much of our labor force obsolete. Indicators that support this hypothesis include historically high numbers of long-term unemployed people (greater than 6 months), and particularly the disproportional impact that this latest recession has had on blue collar America. This is likely a sign of a significant secular change in the labor market as opposed to a cyclical change driven simply by the business cycle or structural deleveraging.

The Bank of Japan spent a decade lowering interest rates and attempting to stimulate aggregate demand through quantitative easing and outsized stimulus packages. Japan dramatically increased their monetary base, more than doubling it year over year for several years and the end result was continued deflation. We know that the money multiplier effect is needed to materially impact inflation; this is the issue that the United States is currently facing. Despite negative real interest rates of about -1.00% for the ten year, credit is tight and there is no appetite for risk in the market. Japan has shown that just increasing the monetary base, even dramatically as the United States has done, does not necessarily equal higher inflation or inflationary expectations.

After ten years of pursuing accommodative fiscal policies, Japan has been left with massive deficits in the public sector which can not begin to be covered in the absence of material economic growth. The United States is going through secular changes in the labor market, running huge public sector deficits, facing "zero bound" interest rates, operating far below economic capacity, and unable to achieve and maintain appreciable gains in aggregate demand. Also, commercial banks are continuing to buy securities instead of lending and this shows that there is still hesitation to invest and take risks in the commercial banking sector.

These fundamentals set up the liquidity trap and make the conditions theoretically perfect for similar outcomes in the United States which Japan has been experiencing for the better part of two decades.

Looking at the unfortunate economic experience of Japan over the last two decades, it is clear that the two economic conditions that must be present to avoid a similar fate are continued GDP growth even if sluggish, and a healthy amount of inflation. In order to create these economic conditions and re-inflate the U.S. economy, risk appetite must improve; in particular the willingness of commercial banks to lend money. Finally, consumers must begin to have the confidence to borrow, invest, and spend again in order to resolve the aggregate demand problem and bring the U.S. economy back to output levels closer to capacity.

Recovering from the Great Recession

It is not all doom and gloom! The last few months have seen small increases in commercial bank lending and continued slow growth in GDP with low levels of inflation. This is exactly what is required to avoid or escape a liquidity trap. However, real interest rates have been creeping upward, which in a "zero bound" interest rate environment where economic output is far below capacity will add to deflationary pressures.

The U.S will need to see long periods of negative real rates in order to continue to encourage investors to add risk to their portfolios. There are great risks associated with the policy the Federal Reserve is pursuing, however an alternative approach given the existing economic conditions is not readily apparent. Furthermore, there are reasons to believe that the Federal Reserve may be able to succeed in their implied objectives.

Recently, we have begun to witness vocal opposition to another round of QE and the Federal Reserve has come under attack somewhat for inappropriate handling of monetary policy. This, in concert with a political environment which has made any government spending and especially QE programs highly controversial among the public, may mean the Federal Reserve's implied goal of controlling inflation expectations might not be as difficult as it otherwise may be in a different political environment. Finally, the Federal Reserve has been able to keep rates near their targets as the demand for U.S. dollars is very strong as a result of the economic troubles in Europe and increasing risks in sovereign credit.

Positioning a Portfolio

There are more than a few unknowns here, including housing which has caused the most damage to consumer's net worth and in extension confidence and willingness to spend. Because of the variables and likelihood for continued uncertainty, investors should proceed with caution. There are low or negative yields in bonds and in a "zero bound" environment - there is vastly more downside potential than upside. A more traditional defensive allocation is likely to perform the best and protect investors from unforeseen market events. As a result of ongoing conflict and instability in North Africa and the Middle East, supply concerns should keep energy prices elevated and therefore portfolios should have exposure to energy and maybe direct exposure to oil. High energy costs also make consumer staples an attractive investment and provide the defensive positioning ideal for these markets. Finally, short exposure to treasuries further down the curve is likely to be the best long run bet with much more upside potential than downside in the current rate environment.

Consider VDE for diverse exposure to the energy sector and BNO as a straight oil play. VDC for your consumer staples and VPU would give you exposure to Utilities and produce nice dividend income. Finally, TBT will provide double short exposure to 20 year treasuries.

Source: A Policy Prescription For The Liquidity Trap