The Rime Of The Modern Fed Chairman

by: Eric Parnell, CFA

The Federal Open Market Committee sets sail once again this week to decide the future direction of monetary policy. And the Fed Chairman enters the meeting with an albatross still hung about his neck.

The ship was cheered, the harbor cleared
Merrily did we drop
Below the kirk, below the hill
Below the lighthouse top

-The Rime of the Ancient Mariner, Samuel Taylor Coleridge

When Ben Bernanke first assumed the Chairmanship back in January 2006, it was certainly much cheerier times for the U.S. economy and its investment markets. And for the first two years afterwards, this general sense of prosperity continued. By the summer of 2007, the U.S. unemployment rate had fallen to cyclical lows at 4.4% and Real GDP growth was expanding at a healthy 3.7% annualized rate. In regards to financial markets, stocks (NYSEARCA:SPY) followed a rousing +15.8% return in 2006 with a respectable 5.5% gain in 2007. During this time, the Fed Chairman notoriously exclaimed before Congress "the impact on the broader economy and financial markets of the problem in the subprime market seems likely to be contained". Of course, such economically tranquil conditions were not to last for much longer, and these problems were far from contained.

And now the storm blast came, and he
Was tyrannous and strong:
He struck with his o'ertaking wings,
And chased us south along

By late 2007, a violent financial storm had descended upon the U.S. economy. Years of easy credit, low interest rates and lax regulation led to a massive housing bubble that finally began to burst. And as this unwind accelerated into 2008, it pushed the direction of the U.S. economy wildly off course. By August 2008, economic growth had begun to stall, the unemployment rate spiked over 6% and stocks had fallen by over -10% for the year to date. But during this fateful summer, Chairman Bernanke in discussing Fannie Mae and Freddie Mac to Congress proclaimed "The GSEs are adequately capitalized" and that "they are in no danger of failing". Of course, both were taken under conservatorship by the U.S. government a mere two months later.

And through the drifts the snowy clifts
Did send a dismal sheen:
Nor shapes of men nor beasts we ken -
The ice was all between.

The ice was here, the ice was there,
The ice was all around:
It cracked and growled, and roared and howled,
Like noises in a swound!"

By the fall of 2008, the U.S. economy and its financial system found itself frozen in a state of catastrophic crisis. In just three months from late August 2008 to mid November 2008, the stock market cascaded lower by over -42% and many major financial institutions either collapsed or were on the brink of failure. Short-term liquidity completely evaporated and even seemingly ultra safe money market accounts were at risk of meaningful loss. And by March 2009, the unemployment rate soared toward 9% and the stock market was posted a -58% peak to trough decline. But then, everything suddenly changed.

At length did cross an Albatross,
Thorough the fog it came;
It ate the food it ne'er had eat,
And round and round it flew.
The ice did split with a thunder-fit;
The helmsman steered us through!

Like the Albatross, a more aggressive form of monetary stimulus known as Quantitative Easing (QE) came blowing in to clear the skies over the economy and financial markets. The Fed's justification for this action was that extraordinary measures were required to save the global economy. For the rest of 2009 and into early 2010, Real GDP turned solidly positive, the unemployment rate peaked and the U.S. stock market exploded higher for a +80% gain. It seemed that the worst was behind us and that the crisis was over. And the Fed Chairman along with Quantitative Easing were widely lauded for their valiant roles in rescuing the global economy. But as soon as QE was removed from the system starting in April 2010, signs of economic and financial market weakness came bubbling back to the surface. It was here where the Fed Chairman may have made a critical mistake.

"With my crossbow
I shot the Albatross"

By so quickly opting to turn to QE2 in August 2010, the Fed Chairman effectively shot the Albatross of monetary policy that had given the economy and markets the strong wind to escape from catastrophic crisis. During the summer of 2010, the economy was no longer on the brink of collapse and stability had been restored to the financial system. Conditions were no longer what could be described as extraordinary. Instead, it seemed more that the system was simply refitting itself in the aftermath of the violent storm through which it had just passed. But instead of allowing the U.S. economy to proceed through this adjustment process given that the economy had been stabilized, they launched into another round of aggressive stimulus. And just as the Albatross was not respected as extraordinary, so too had the extraordinary policies of QE now become ordinary with the decision to so quickly fire away with another round in QE2.

"And I had done a hellish thing,
And it would work 'em woe:
For all averred, I had killed the bird
That made the breeze to blow.
Ah wretch! said they, the bird to slay,
That made the breeze to blow!"

Suddenly the reverence afforded the Fed Chairman for his role in rescuing the U.S. economy turned to scorn, as many decried QE2 as pre-emptive and an unnecessarily reckless overreach in monetary policy action that may not further help the economy but may put it at greater risk for unintended consequences down the road. The key then for this policy decision was the hope that it would succeed in giving the economy that final boost toward sustainable economic growth. Alas and alack, this would not come to pass by the end of QE2 in the summer of 2011.

"Day after day, day after day,
We stuck, nor breath nor motion;
As idle as a painted ship
Upon a painted ocean."

Instead of an acceleration in growth as a result of QE2, the economy effectively stalled even before the program was completed.

"Water, water, every where,
And all the boards did shrink;
Water, water, every where,
Nor any drop to drink."

Despite the fact that the banking system was completely awash in liquidity thanks to Fed policy, only a fraction of this capital was finding its way into lending markets. And many consumers and small businesses struggled to qualify for a loan. Thus, the banking system had been saved, but the economy was continuing to rot.

"Ah! well-a-day! what evil looks
Had I from old and young!
Instead of the cross, the Albatross
About my neck was hung."

The Albatross of extraordinary monetary policy that had guided the economy back from the brink now hangs about the neck of the Fed Chairman. And with this comes the burden of expectations from financial markets and mounting scrutiny from politicians in Washington. What was once a policy that was only being used because the financial system was about to collapse are now measures that investors expect the Fed to utilize every time we have a disappointing employment report or jobless claims rise unexpectedly. And once these expectations are in place, they are nearly impossible to reverse without a major reaction from within the financial system.

So where does our monetary captain stand today as he rejoins his committee for the latest policy meeting this week? Rumors abound in the marketplace and the business media that another round of aggressive policy action will soon be forthcoming. Why? Because economic growth has fallen into recession? No. Because employment growth has turned negative? No. Because stocks are down for the year? No. Instead, the market is expecting further once extraordinary, now ordinary policy measures from the Fed because the still sluggishly growing economy MIGHT be slowing back toward recession and the situation in Europe MAY be descending toward crisis in the coming months including an election outcome in Greece that may be less than favorable for the markets. Frankly, I don't recall the policy precedent where the Fed decides to ease because democracy has spoken in a foreign country such as Greece, but these are unusual times to be sure.

What should the Fed do this week? They should remain on hold with current policy, allow Operation Twist to expire at the end of the month and take no further action at the present time. They should, however, provide reassurance that they stand ready to act with an appropriate policy response IF and WHEN any crisis situation was to unfold in the coming months. Otherwise, they have done more than enough to support the economy, to the point they may be hindering it.

But what will the Fed actually do? Because the Albatross of further monetary easing expectations now hangs about the neck of the Fed Chairman, they risk a major correction if they do not deliver what the market is anticipating and demanding. For any advance in stock prices nowadays has little to do with fundamentals and everything to do with whether the Fed plans on pouring on more monetary stimulus. By fostering the conditions that created these expectations, the Fed has now effectively painted itself into a box. Ease later and shock the market with disappointment. Ease now and hamstring the ability to apply more targeted monetary stimulus when it is truly needed. In recognition of this tightrope, the Fed may try to keep policy unchanged but provide generously suggestive winks and nods that more monetary help is likely soon on its way. Whether this verbal approach would be enough to assuage investment markets is subject to debate. But the fact that the tone for investment markets for the next several months is being set by an election in Greece and what the Fed may or may not say at any moment highlights how stormy the environment is that were still trying to navigate. Thus, risks remain high, at least in the short-term, even if investors get most if not all of what they want from the Fed this week.

For these reasons of extended uncertainty, the priority for investment portfolios remains being hedged. This includes allocations to those areas of the market that can perform well regardless of the stock market like U.S. TIPS (NYSEARCA:TIP) and Agency MBS (NYSEARCA:MBB), the latter of which is likely to be the primary target of any upcoming Fed stimulus program. Long-Term U.S. Treasuries (NYSEARCA:TLT) also offer appeal as a hedge against recession and a declining stock market. Lastly, Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) offer appeal from the ability to outperform both during times of aggressive stimulus as well as crisis. Of course, allocations to high quality stock names such as McDonald's (NYSE:MCD) and Tootsie Roll (NYSE:TR) also have merit in hedging against another stimulus driven spike higher.

"He went like one that hath been stunned,
And is of sense forlorn:
A sadder and a wiser man
He rose the morrow morn."

Looking ahead, hopefully the Albatross of expectations will eventually fall from the neck of the Fed Chairman. For more than anything, the economy and financial markets require the opportunity to clear and refit before we can finally begin sailing our way toward a new secular bull market. In the meantime, continue to stand ready for the latest upcoming comments from Chairman Bernanke and the Federal Reserve, for it remains among the primary drivers of market behavior on any given day.

Disclosure: I am long GLD, MBB, MCD, SLV, TLT, TIP, TR.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.