Dramatic Change In The Air At The Fed?

by: Stephen Leeb

You wouldn’t know it from the press coverage, but we may have reached one of the most important turning points in recent U.S. economic history. The watershed event: The Federal Reserve’s policy setting meeting at the beginning of this month. While it's true the Federal Open Market Committee (FOMC) meeting did not result in an announcement of any changes in Fed policy, the discussions during the meeting strongly suggest the central bank is now leaning ever closer to a greater toleration of inflation and a much stronger commitment to lower unemployment.

Specifically, the most telling indicator was that the three previous dissenters to the current “easy” policy no longer dissented, even though the most critical economic indicators have not worsened. Indeed some indicators, e.g. unemployment insurance claims, have actually improved; the same goes for the Conference Board’s Index of Leading Economic Indicators, which continues to show a distinct uptrend.

But at this meeting there was a new dissenter: Charles Evans, President of the Federal Reserve Bank of Chicago.

Evans’ dissent was informed by his belief that the Fed should be following an even easier policy, i.e., buying additional securities, otherwise known as more quantitative easing. As we have mentioned before about Evans, his view in simple terms is that the Fed should target unemployment until a reasonable level is reached, say 7.5 percent, and then refocus on inflation.

In other words, there are now four out of the 10 FOMC members who have switched direction in the face of economic news that has been less than noteworthy.

What gives? Perhaps the most important clue came from the very hawkish Richard W. Fisher, head of the Federal Reserve Bank of Dallas and one of the three previous dissenters. As we pointed out in our last issue, when asked about the recent and widespread protests against Wall Street, Fisher singled out unemployment as a bigger problem than inflation and commented on widening income disparities in the U.S. – which has been a major factor in the protests.

Of course, income disparities would hardly be a big deal if those in the lower income levels had at least a relatively good living standard, i.e., no problem in paying for life’s essentials and some money left over to enjoy a few discretionary purchases. But what we are seeing today is a situation where the lower and now even middle classes are increasingly financially squeezed to such an extent that their incomes leave little or no room after the costs of energy and food.

These points clearly can be seen in a couple of charts. The first shows the food and energy expenditures for the different quintiles of the population averaged over the years 1999-2009. Two numbers stand out. First is that the bottom 20 percent spent over 44 percent of their income on food and energy. A more subtle point not reflected in the chart is that for the bottom 20 percent, overall expenditures were considerably more than their entire income. How can that be? Credit a combination of savings, government programs, and where possible, borrowing. To a lesser extent, the same is true for the second-to-lowest 20 percent. And, indeed, were you to look at the bottom 60 percent you would find that this group on average had to borrow in order to satisfy their consumption of life’s essentials.

In our second chart, we show the same data just for 2010, and as you can see, what was bad has gotten much worse. The lowest 20 percent, for example, now spend a nearly unbelievable 55 percent of income on food and energy. The other data also speaks for itself. So we would say that Richard Fisher and other members of the Fed are getting the message that America is in desperate need of more growth…or else nothing else may matter.

One final point: Does it really make sense to exclude food and energy from inflation figures? Actually, no question mark should be needed there, as after a decade of rising prices for these essentials this is a purely rhetorical question. With overall inflation already at 3.9 percent we can safely assume that for the majority of the population this is the number that truly matters. With more stimulus on the way, the bet on much higher inflation seems to be a compelling one indeed.

In connection with this issue of today’s wide income disparities and the difficulties large numbers of Americans have in making ends meet, we must comment on the appalling story reported on Sunday night’s 60 Minutes exposé of Congressional insider trading.

Essentially, it described how members of Congress are exempt from laws that apply to everyone else in America that frequently result in jail time when it comes to trading on inside information. In fact, many on Capitol Hill have become wealthy as a result of this exemption, having profited handsomely from trades made on the basis of their knowledge of impending legislation.

The corruption is non-partisan: Both Republican Speaker John Boehner and his Democratic Party predecessor, Nancy Pelosi, are shown to have made highly questionable trades along these lines – and both deliver poker-faced denials of any wrongdoing or impropriety when asked about it. Pelosi and her husband have also benefitted inordinately from advantageous treatment in opportunities to buy pre-IPO shares on eight different occasions.

Then there’s Spencer Bachus, Alabama Republican and Chairman of the House Financial Services Committee, who made a killing putting on short positions in 2008 right after learning about the upcoming market meltdown from Fed officials and other government insiders. So a lawmaker whose job is to protect and prop up our economy against a crash meanwhile bet his money on a downturn – and won big! Talk about voting with your dollars…

It gets even worse: The report described how a thriving business has developed in Washington which specializes in gathering such inside information from legislators and/or their staffs (they call it “business intelligence”) for resale at appropriately lucrative fees to hedge funds and other investors wealthy enough to pay for it.

Congressmen earn a salary of something like $174,000 per year; yet virtually all of them leave Washington much wealthier than when they arrived. To be sure, insider trading is not the only way legislators manage to become corrupted, and it’s not just a matter of building personal wealth: Our electoral process makes raising large sums of money a necessity if one is to have any chance at running for reelection competently.

In any event, the bottom line is the same: legislators who are largely bought and paid for by those with the means to foot the bill. At the same time, can such political leaders really understand the economic difficulties of middle and lower class Americans today, and be motivated or relied on to enact effective legislation on their behalf?

For all its faults, the Federal Reserve Board has strict requirements and regulations forbidding its members from capitalizing on inside information the way Congressmen can freely do. So while many politicians call for abolishing the Fed, I would sooner call for abolishing Congress instead! (Full Disclosure: the latter is meant facetiously; please don’t write me irate emails!)

Are there any investment strategies to be drawn from what we’ve covered in today’s Market Update? As a matter of fact, there’s one I can think of immediately. File this under: How to capitalize on the outrageous ability of Congressmen to trade on inside information.

Use the internet to monitor legislation before Congress or about to come before it, then employ a momentum trading approach to identify and then profit from investments that will be likely beneficiaries. As you probably know, momentum trading involves finding stocks that are moving strongly in one direction on high volume. Positions tend to be held for short periods, typically ranging from less than an hour to an entire trading day, and they do require close attention in case there’s a change in direction. So it’s not for everybody.

As far as easier bets: In the event that we do see further easing from the Fed soon, 1) you can expect to see a surge in stocks across the board; and 2) the increased threat of higher inflation will favor gold and silver – in which case, all our usual favorites apply.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.