October 18, 2010
Dear Friends and Clients: Q3 2010 Commentary from Andorra
Crank up the printing press “The FED and Monetary Policy”
“Opportunity is often missed because it is dressed in overalls and looks like hard work”.
This quarter’s newsletter while not dressed in overalls, may be interpreted as “hard work” because the FED and its’ activities can often be confusing which is further compounded by double speak from Chairman Bernanke (and especially when Greenspan was at the helm). But, a strong effort should be made to interpret current FED intentions as this is likely to have long-term impacts both domestically and abroad. Anyone with investable assets should take note.
The Federal Reserve System was created by the Federal Reserve Act, enacted by Congress in 1913. This essentially created the FED and our modern banking system as we know it today. The motivation to create such a system was due to multiple financial panics that wreaked havoc on the United States economy. When it began the FED was intended to provide liquidity to the financial system, act as a lender of last resort and “smooth” the business cycle. Today it has additional functions, some of which have been mandated by Congress. Whether or not the FED is controlled by the U.S. government is often debated. Directly, the FED is not “part of government” and is intended to be a semi-autonomous institution free from partisan politics to pursue its’ mandate through monetary policy. To this day it is an often misunderstood institution peppered with conspiracy theories about who controls it and its true objectives (just type in FED, money supply and conspiracy into Google).
Simply put, through control of the money supply (monetary policy = money supply) the FED seeks “maximum employment, stable prices, and moderate long-term interest rates” (source: Purposes & Functions of the Federal Reserve System). This translated basically means that the FED is supposed to be the main entity that controls the economy through monetary policy to achieve its’ “mandate” (referenced above). This is why the FED is so important! Understanding where the FED is headed through monatery policy decisions can be very telling of the economy and interpreting these signals should impact investment decisions.
OK, so what is monetary policy (MP)? Just think about money supply and how it can be, ummm…manipulated. The FEDs most often discussed tool to either stimulate or cool the economy is through control of the Federal Funds Rate (just think “interest rates”). If the FED increases the federal funds rate the intention is to cool the economy as their mandate of “stable prices” is likely running above plan. Translation, if inflation is heating up the FED will increase the federal funds rate in an effort to increase interest rates with the intention of slowing the economy though a constriction or “tightening” of the money supply. Remember, “stable prices” is one FED mandate and high inflation can be detrimental to economic stability. Currently we are obviously not generally experiencing rising prices in the economy. The FED will often refer to an “easing or tightening bias” in their minutes when discussing interest rate direction and the economy.
Right now deflation is a real concern and the FED has explicitly stated that it will “consider it appropriate to take action soon”. Currently the FOMC (Federal Open Market Committee) has reduced its’ federal funds rate to 0-0.25% as of December 16th, 2008. Interest rates have been virtually near zero for almost two years! In the 1990 this rate hovered basically in the 3%-5% range and 8%-18% during the 1980s. Now this is a good time to ask yourself, interest rates have been lowered to near zero and two major things have happened, or not happened. The economy is still very sluggish and interest rates are 4%-5% for a mortgage and anywhere from 8%-12% for credit cards. If the FED has targeted rates at 0-0.25% level and consumers have to pay substantially more for credit or a loan where it the difference going? BANKS!!! So the FED dropping rates to virtually zero for banks should incentivize them to lend. The problem on this front it twofold, banks have become reluctant (strict) to lend and consumers (you and I) have not wanted to take on any more debt. These two factors combined have led to low credit creation and a recent spike in the household savings rate. On the balance this is a good thing that U.S. households are paying down debt and beginning to save more money, but at the same time this is a negative factor for businesses.
Now back to the FED and with interest rates to levels at which they cannot go any lower, what do they do? Crank up the printing press! The FED is desperately afraid of deflation. Here is where things become very complicated. “Normal” actions of monetary policy are to either the increase or decrease in interest rates which normally makes it either cheaper or more expensive to borrow. But cheap money has not jump started the economy and the FED is switching to Plan B, Quantitative Easing (or “QE” for short). QE is simply the FED (or any other central bank) increasing the money supply. This is intended to push up asset values as the FED will enter the financial markets and buy long dated Treasuries and “other assets”. One direct objective of QE is to drive up values of financial assets which will, in turn push market interest rates down and drive equity values up. Lower interest rates for businesses and consumers, while the economy gets a boost from more dollars flowing in the financial system sounds like a good plan, right? The problem is financial markets are very adept at incorporating a new level of supply into market prices, meaning the dollar will drop in value. This has already begun to happen as the market has heard rumors of QE the dollar has slid in value versus most major currencies. Non U.S. dollar denominated assets and commodities have already jumped in value.
So, the FED has stated its’ intent to fight deflation and create a healthy level of inflation in the economy. This will at best be a delicate balance. In the short run positive outcomes from this policy should be decreased borrowing costs, increases in business investment driven by higher demand for exports due to a declining dollar, which should eventually flow through to higher employment and then the Holy Grail…a happily employed consumer with a rebuilt balance sheet. To quote PIMCO, “the possibility for policy errors is high”. Down the road potential negative outcomes from this policy are that consumer inflation will increase as the dollar weakens with import prices rising steadily. Investors will likely rush in to commodities as a dollar hedge which will drive prices even higher. Asset prices may also increase at a fast pace with wages not keeping pace and further leading to another boom and bust cycle that we have just experienced. In pursuit of economic growth the FED may be setting the stage for another financial crisis due to an asset bubble fueled by loose monetary policy. But as witnessed before, history has taught us that bubbles are hard to predict and may go on for far longer than anticipated.
While most remain cautious that the economy is in a slow recovery mode as private sector employment has begun to pick up, public employers are still hurting and shrinking their workforce as this segment of the labor market is very much a lagging indicator due to reduced tax revenues. It is estimated that 1 in 7 jobs are due to a state or local government employer. Businesses have reduced prices when necessary and current deflationary conditions that the FED is trying to fight are indicators of the lengths to which businesses will compete to maintain market share in a weak economy. In addition to the QE debate and the impact on inflation, two vocal groups have emerged on the debate over fiscal policy. One side is supporting government stimulus spending and another is advocating that the federal government pay down debt and cut public spending. These “austerity measures” to reduce debt and spending levels, and their impacts are hotly debated. In Europe these issues are literally causing riots in the streets (see France’s recent pension reform proposals and the public’s reaction). In the U.S. it’s likely that proactive policy action will continue, while at a reduced level on the fiscal side, with monetary policy initiatives that should increase the likelihood of a sustained economic recovery. Continued high unemployment with a potential for inflation hitting the U.S. consumer could be a stagflation cocktail if the FED doesn’t properly execute on its’ QE plan.
QE will reduce the potential for a deflationary spiral. With that, it must then increase the likelihood of inflation. This is all predicated on the FED launching its QE2 policy as it has commonly become known in the financial press. Again, the risk for policy errors is high as this is a highly unusual activity. This will be a balance on the “deflation-inflation rollercoaster” and the debate may continue for some time.
As mentioned in my previous newsletters look to diversify away from U.S. dollar denominated assets (in accordance with risk tolerance) as the FED weakens the dollar in the coming months. This will be a classic “risk on” trade where EM debt and equity and both DM and EM high yield should perform well. Also, the addition of TIPS and other inflation protected assets would be a good diversifier to portfolios. This has been a good strategy and should continue, but not forever. As the FED moves to weaken the dollar and spur spending at some point in the future liquidity will have to be unwound from the financial system. When the inflation pump has been primed U.S. government debt will be repriced with a huge downside risk. But exactly when that will happen, we’ll have to wait and see.
Disclosure: domestic and international debt and equity ETFs and Mutual Funds