Fed's Actions Leave Me Skeptical and Confused

by: David Merkel, CFA

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them. That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff: 'Is the Fed Ahead of the Curve?' It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.” In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not. My opinions have been:

  • The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
  • The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
  • The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity. (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
  • Instead, they try novel solutions such as the TAF. They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
  • We will get additional consumer price inflation from this.
  • We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet. Commercial real estate is next. Consider this fine post from the excellent blog Calculated Risk.
  • The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation. Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another depression occur on his watch. I think that is his most strongly held belief, and if he feels there is a modest risk of a depression, he will keep policy loose.
  • None of this means that you should exit the equity markets; stick to a normal asset allocation policy. Go light on financials, and keep your bonds short. Underweight the U.S. dollar.
  • I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets. Take for example, this article on the BlackRock Cash Strategies Fund. In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections. Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock. Look, I’m not calling for a depression, or stagflation, at least not yet. At RealMoney, my favored term was “stagflation-lite.” Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it). A few comments on the two articles:

  • First, international capital flows from recycling the current account deficit provide more stimulus to the U.S. economy than the FOMC at present. Will they stop one day? Only when the U.S. dollar is considerably lower than now, and they buy more U.S. goods and services than we buy from them.
  • Second, the Federal Reserve can gain more powers than it currently has. If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets. If not Congress, there are executive orders in the Federal Register already for these actions.
  • Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
  • Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive. In a crisis, though, anything could happen.
  • Fifth, I don’t see a crisis happening. It is in the interests of foreign creditors to stabilize the U.S., until they come to view the U.S. as a “lost cause.” Not impossible, but unlikely. The flexible nature of the U.S. economy, with its relatively high levels of freedom, make the U.S. a destination for capital and trade. The world needs the flexible U.S., less than it used to, but it still needs the U.S.

One final note off of the excellent blog Naked Capitalism. They note, as I have, that the FOMC hasn’t been increasing the monetary base. As I wrote at the end of last week in RealMoney (The Fed Has Shifted the Way it Conducts Monetary Policy):

Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3: total bank liabilities from the H8 report ( ALNLTLLB Index for those with a BB terminal). It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

The Naked Capitalism piece extensively quotes John Hussman. I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations. My observations could be wrong here. I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard to reflate dud assets (and the loans behind them) now. That excess liquidity will find its way to healthy assets, and I think I own some of those.