Bernanke Stays the Course: Understand the Fed and Invest Accordingly

by: Bernard Thomas

The FOMC concluded its meeting and released its statement. Later in the afternoon, Fed Chairman Bernanke held the first ever post-meeting press conference. Nothing stated by the FOMC or by Mr. Bernanke himself was surprising, at least not to me.

This was not necessarily the case for many market participants. The airwaves were filled with comments made by pundits predicting language leaving open the possibility of an early end to QE2. Others predicted that the Fed would announce that it would consider not reinvesting the proceeds of maturing assets. Others still were predicting that the Fed would drop “extended period” from its statement regarding the Fed Finds rate. Alas, none of these were to be,

The Fed decided to permit QE2 to run its course, announced that it plans to reinvest proceeds from maturing QE2 assets and that policy will remain accommodative for an extended period of time. The decision to leave the course of policy unchanged was unanimous. Even Philadelphia Fed President Plosser and Dallas Fed President Fischer, two outspoken inflation hawks and QE2 critics, voted for staying the course.

In his statement read at the press conference, Fed Chairman Bernanke stated his case for staying the course, expressed concern that the growth may be moderating and called inflation pressures transitory. What Mr. Bernanke my mean is that food and energy prices are self-limiting and, in the case of oil prices, at least partially driven by speculation. The Fed has traditionally resisted being held hostage by speculators.

Arguments that the Fed could help the economy by raising rates, strengthening the dollar and putting more money back into the hands of the consumer. Although this idea has its merits, it must be acknowledged that the recovery we have seen thus far is a balance sheet recovery due to cheap corporate financing and favorable exchange rates for export business. Raising the Fed Funds rate before employment and housing recovers could send corporate profits and the equity markets plummeting. The results could include a new round of layoffs and further depression in the housing sector (Mr. Bernanke’s description of housing was “depressed”).

So what does this mean for interest rates? It obviously means that short-term rates, such as Fed Funds and three-month LIBOR, will remain low. It could mean that long-term rates remain somewhat low. However, long-term rates could rise modestly as Fed policy will remain accommodative and foster some inflationary pressures. The opposite could occur when the Fed begins to tighten as disinflationary policies could result a halt to rising long-term rates before they gain much traction, but that is probably a year away.

Many readers will respond that they do not agree with Fed policy and therefore will choose investment strategies which run counter to Fed policy. One bets against the Fed at one’s own risk. The Fed sets policy, not me and not you. My personal view is that the economy needs a cleansing from borrowing and we as a nation must learn to live with in its means. However, that is not only impractical at this time because it would likely result in a recession which could be crippling, but also is not consistent with the Fed’s dual mandates of price stability and job growth. My views of what should be done are irrelevant. We only need to understand what the Fed will do and why and invest accordingly.

Make no mistake; the Fed cannot fix the economy. Mr. Bernanke knows that as well as anyone. He is just trying to keep things chugging along until the boys and girls on Capitol Hill make the necessary tough choices to make the economy fundamentally sound. What those choices are is a discussion for another day.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.