Fed: Still Smoking In Bed As The Town Burns

by: Eric Parnell, CFA

The Fed has lost its way. It was a little over three years ago that we were first introduced to the implementation of extraordinary monetary stimulus in the form of Quantitative Easing (QE). At the time in March 2009, the U.S. Federal Reserve and its Chairman Ben Bernanke were sensitive to the fact that many in the American public were reacting badly to such aggressive policy actions to help rescue the banks and Wall Street. To this he offered the following explanation during a television interview on 60 Minutes.

"Let me give you an analogy, if I might. If you have a neighbor, who smokes in bed. And he's a risk to everybody. If suppose he sets fire to his-- to his house, and you might say to yourself, you know, "I'm not going to call the fire department. Let his house burn down. It's fine with me." But then, of course, but what if your house is made of wood? And it's right next door to his house? What if the whole town is made of wood? Well, I think we'd all agree that the right thing to do is put out that fire first, and then say, "What punishment is appropriate? How should we change the fire code? What needs to be done to make sure this doesn't happen in the future? How can we fire proof our houses?" That's where we are now. We're having-- we have a fire going on."

--Fed Chairman Ben Bernanke, 60 Minutes, March 15, 2009

At the time, I agreed firmly with the Fed's actions. Certainly, action was required against the financial institutions that had the global economy on the brink of collapse. But it was important to first pull the economy back from the precipice and stabilize the system before considering such measures.

While the Fed managed to succeed in stabilizing the financial system with what is now known as QE1, along the way it lost sight of it objectives of what would be done after the system was stabilized. For QE1 was eventually followed by QE2, Operation Twist and potentially QE3 before it is all said and done.

I have strongly objected to every policy action since QE1. My reasons are as follows. Revisiting Chairman Bernanke's analogy from March 2009, massive sums of fiscal and monetary stimulus were expended to rescue the neighbor who smokes in bed. But we agreed to rescue the neighbor on the premise that once the fire was extinguished we would then consider what punishment is appropriate, how the rules needed to be changed, what needed to be done to make sure it doesn't happen in the future and how the system could be best protected going forward. Much to the dismay of many in the American public, virtually none of these actions have even begun to occur several years later.

In short, the Fed has not kept up their end of the bargain. Instead, we have the following. Not only is the neighbor still smoking in bed as evidenced by the recent "London Whale" debacle at JP Morgan Chase (NYSE:JPM) among many examples, but the Fed is now wringing it's hands to make sure that the neighbor has its favorite cigarettes by its bedside at all times as evidenced by its recent concerns that it did not want to disappoint Wall Street with its latest monetary policy announcement. All the while the American public toils away in a town that remains ablaze in the persistent backdraft of a sluggish economic recovery and a highly uncertain outlook. Millions are still out of work if they've bothered to stay in the labor force at all. And many consumers, even those of the highest credit quality, are still struggling to get access to needed credit as banks have tightened lending standards and made borrowing a far more cumbersome process.

The Fed has let the American public down. They promised that once they stabilized the system they would take the necessary steps to punish the bad actors and make certain that we would not face the same risks of having a the failure of a select group of systemically important financial institutions implode the economy. But here we are over three years later and although the system has been stabilized, the Fed continues to shovel more and more stimulus toward banks and Wall Street at the expense of many in the rest of the economy.

So what can we expect from the Fed going forward? The November election will be a pivotal moment not only for the Presidency but also the Fed. For if President Obama wins re-election, it should be expected that Chairman Bernanke will continue on the current policy course. However, if Governor Romney were to win the election, it is reasonably likely that he would follow through with his previously stated intent of replacing Bernanke with another Chairman that would almost certainly advocate a different approach that would likely include a greater focus on price stability and restraint on further policy stimulus. This will be an interesting topic to monitor in the months leading up to the election.

In the meantime, the Fed remains likely to deliver another pack of cigarettes in the form of QE3 in an effort to try and quell the blaze that still burns about town. Such a delivery would likely occur if we see stocks cascade lower at any point in the coming months. And this is a distinct outcome given the risks emanating from the ongoing crisis in Europe and the slowing global economy. Thus, it remains worthwhile to consider holdings in securities that would directly benefit from such an outcome. These include precious metals such as Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV). This also includes holdings in high quality, low volatility stocks that can hold up relatively better during periods of uncertainty but can also participate during any swift QE3 propelled market advance. Representative names to consider include Microsoft (NASDAQ:MSFT), Wal-Mart (NYSE:WMT), ExxonMobil (NYSE:XOM), McDonald's (NYSE:MCD), Nike (NYSE:NKE) and Procter & Gamble (NYSE:PG). Lastly, hedging a portfolio against the potential for a swift stock market decline that may occur along the way through negatively correlated categories such as Long-Term U.S. Treasuries (NYSEARCA:TLT) is also prudent.

I believe Ben Bernanke is a good man with the best of intentions in trying to rescue the U.S. and global economy from crisis. And I trust that he will continue to do whatever is in his power to try and support a sustained economic recovery. But I fear he may have lost focus of his original objectives along the way. And the dogged focus on feeding financial institutions and Wall Street with stimulus at all costs may ultimately have consequences that may prove dire to the economy the more the Fed extends itself in this effort. It will be interesting to see.

Disclosure: I am long MCD, NKE, PG, TLT, GLD, SLV.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.