Cause For The Fed's Panic: Diminishing Returns From Monetary Stimulus

by: Mark E. Bachmann, CFA

While a near-sighted stock market cheered the Fed's announcement last Thursday that it will initiate another round of Quantitative Easing, long-term investors in my opinion should be alarmed.

The Fed was unusually clear about its intentions: to pour $40 billion in newly-created Fed dollars into the agency MBS market every month between now and the end of the year. Additionally, the Fed will extend its grasp even further out on the maturity curve than previously by rolling over debt already on its balance sheet into longer-term securities. In total, Mr. Bernanke and his colleagues will be providing $85 billion monthly in artificial support for what they clearly see as a very sick market.

And the Fed didn't stop there. Thursday's announcement reminds us of the Fed's "dual mandate" and informs us that the Open Market Committee will continue these programs, augmented by "additional asset purchases" as needed, until "improvement is achieved" in the labor market, i.e. a meaningful drop in unemployment. The announcement at least mentions inflation and reminds us that the Fed now has a "2% objective" - not a ceiling mind you, but an objective - and anticipates that inflation "over the medium term" will run mostly under this objective, apparently regardless of the amount of new money entering the system.

The Problem

It does not take a professional Fed Watcher to see that our central bank is laying the groundwork here for an indefinite period of increasingly aggressive asset purchases. It feels compelled to drive down the long-term interest and unemployment rates, and fan what it apparently regards as dangerously low inflation, as though oblivious to any countervailing risks.

It also does not take a professional economist to see the self-destructive trap being laid. While there is there is surely a relationship between interest rates and unemployment, there is no linear connection, nor any reason to believe the data Mr. Bernanke is observing now will still be relevant by the time his actions have impact. He must feel like an artillery captain firing at targets on a distant hill, knowing that the enemy may move by the time his shells explode and that the only effect from his barrage may be wasted ammunition and collateral damage. Yet he feels compelled to keep blasting away because he has no other weapons. This is, of course, a dissipating syndrome.

Radical Policy

Quantitative Easing, now known with such fond familiarity as QE, has been a hidden arrow in the Fed's quiver for a long time. While the term itself was coined fairly recently, a version of QE was employed during the Great Depression, and there are even antecedents going back to the monetary "panics" of the 19th century. But bankers always regarded it as an extreme and potentially dangerous tool, and one to be considered only in the direst emergencies.

There's no mistaking the picture now unfolding: our economy is being subjected to radical monetary policy. Yet Mr.Bernanke and his colleagues are not radical people. So what's going on here? The answer has to be that they are in a panic about something, and there can hardly be any mystery about the source of their consternation.

Leveling Trends

On the very same day the Fed dropped its explosive new gift on the markets, SA Contributor Alan Brochstein published an article with the understated title: "Time To Think About Minimizing Interest Rate Risk In Your Portfolio" (Seeking Alpha, September 13). Talk about serendipity! Mr.Brochstein presents us with a chart depicting the course of 30 and 10-year Treasury rates from 1981 to the present. We all know this data, of course, but as Mr. Brochstein says, "there's nothing like a 32-year perspective to really illustrate the extremity." Indeed there's not. Rates have dropped inexorably now for three decades. Upticks, where they have occurred - 1987, for example, or 1994, or 2000 - have led to brief bouts of market instability followed by massive infusions of liquidity from the Fed. The secular downtrend always resumed and the market turmoil abated. We could, of course, on top of this data superimpose charts of the S&P 500 and U.S. GDP to get the full picture of how dependent our markets and our economy have become on expanding liquidity and steadily falling rates.

In his book "The New Depression," maverick economist Richard Duncan examines this and a lot of other data. He raises the question of why such a sustained avalanche of liquidity hasn't triggered hyperinflation. He concludes that cheap imports from China and other countries have driven what he calculates as a 95% decline in the marginal cost of labor. In his equation, declining labor costs have meshed with expanding liquidity to give us several decades of non-inflationary economic growth and rising asset values. He believes, however, that these trends are leveling and that we've reached an explosive inflection point. His book's title reflects the bad times he sees ahead.

Investment Implications of the Fed's Played-Out Strategy

I'm sure that Ben Bernanke is not expecting economic apocalypse, but he knows the dangers that can arise from leveling trends. Short-term interest rates are already effectively at zero, and long-term rates too are approaching their bottom most limits. Mr. Bernanke knows that the period of leveling rates correlates with the period of economic malaise we are in. For all the massive stimulus we've seen, unemployment is still high and economic growth is tepid. With the announcement his institution put out on Thursday, he seems to feel he can somehow blast his way out of the cul-de-sac he's in.

Alan Brochstein's piece also focuses on leveling trends, but he arrives at fairly moderate conclusions. All he's trying to tell us is that long-term bond investors are facing negative returns soon if they don't re-balance their portfolios. I see things a little differently, since I believe the Fed is now likely to continue QE well into next year and maybe a good deal longer. With the world's most powerful bond investor staring at me from across the table, I would not want to be betting against his trades for now. Long bonds may hold their ground a while longer.

Longer term, however, the Fed's strategy has to play itself out, and when that happens, the nature of the game will change explosively. If other more positive variables don't enter the picture, we will be confronting a crisis the nature of which is impossible to analyze today.

As investors concerned about the future, we can't simply crawl into protective holes with our money. Gold and other traditional hedges against adversity are likely to be losers in the near future, and longer term may not work anyway as they have during past crises. The only rational course I can see for now is to invest prudently with a relatively short-term horizon in mind and then be prepared quickly to size up the new environment when it arrives.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.