Fed Gets Aggressive: Willing To Risk Some Inflation

Includes: ABX, AGG, DIA, GDX, QQQ, SPY
by: James A. Kostohryz

The Fed's Statement could hardly have been more bullish for stocks in the short-term. This was the key sentence:

"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."

In other words: "We will keep printing aggressively until the job market improves, up to the point where inflation becomes a problem."

Another important sentence was:

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."

By saying that they will continue high levels of "accommodation" after the recovery strengthens implicitly suggests that the Fed is willing to risk inflation for the sake of supporting employment growth.

Bernanke strongly reinforced a bullish interpretation of the Fed statement. In particular, he stated that the Fed would not "rush" to raise rates once the economic recovery accelerated. In particular, he seemed to hint that the Fed would tolerate core inflation of over 2% by saying that the Fed would seek to be "balanced" in bringing its inflation and employment back to their targets. Since the Fed's target for the core is already at 2% this strongly suggests that Bernanke perceives the future need to bring inflation down to its target in the future (after it has overshot a bit).


Amid the short-term bullishness that the Fed's statement is sure to unleash, there are some potentially disturbing developments when analyzed from a longer term perspective.

First, the Fed is implicitly admitting that it is playing with fire. In other words, by making the ignition of inflation its trigger for reigning in accommodation, the Fed risks igniting a fire of unintended scope and effects.

Second, market participants should remember that the Fed does not control interest rates in the broad economy. The Fed can help keep rates down at the short end of the curve and can even keep rates down to some extent at the long end of the curve in some markets. However, the aggregate bond market is far bigger than the Fed. If inflation rears its head, even modestly, the Fed will be virtually helpless to contain the spike in rates in private credit markets. The effects of such a spike in private credit market rates, in a highly leveraged economy, could ultimately prove far more contractionary than the temporary expansionary effects of its currently proposed stimulus.

Market impact? QE3 was expected. But the Fed's statement was far more aggressive than anticipated by market participants. In the short-term, stocks and ETFs such as (NYSE:ABX), (NYSEARCA:GDX), (NYSEARCA:SPY), (NYSEARCA:DIA) and (NASDAQ:QQQ) should rally.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.