And Then There Was the FED

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At this writing the Federal Reserve has just announced a strategy for unwinding the $85 billion-a-month buying spree. What will this move mean to you and me? In case you are not aware, the Fed has been buying bonds on the open market at the rate of $85 billion a month since last September. The bond buying programs, the first of which began in 2008, were designed to push down long term interest rates and to push up sentiment that would hopefully lead to more borrowing, spending, and ultimately more hiring in the broader economy. The economy however has not responded.

When the Fed buys on the open market, it turns to its primary dealers (about 20 large banks) and issues reserves in exchange for those bonds. It is hoped that those reserves will stimulate the economy via loans, by a multiplier of 10 to 1. In order for the desired effect (growth in the economy) to occur, those banks must be willing and able to lend, AND they must find willing and able borrowers. What has happened is that the banks have either chosen or been forced to simply hold the reserves. They have then used their other capital to bolster their investment portfolio, driving the stock market to new heights.

The announcement left the bosses at the Fed plenty of wiggle room. Officials have said that they plan to reduce the amount of bonds they buy in careful steps, leaving room for turning the dial back up or simply holding it at a given level for quite some time. They would not hint at a date for beginning the shift.

Even to suggest that they might increase the amount of bond buying left some market analysts scratching their heads. Did such an acknowledgement mean that the economy is actually slowing down and that he Fed believes that more stimulus might be needed? The data from April seemed to bear that out. Employment data were weak and inflation has once again dropped. We, like everybody else, have to wait and see. Meanwhile you and we have to make investment decisions in a highly complex world. Where does this leave us? Let’s go back to fundamentals.

We happen to believe in the primacy of GDP growth as the principal driver of future prosperity in our society. As you may recall, Federal spending is an additive component of GDP while taxes subtract. But most recently government spending has been reduced as a result of sequestration and taxes were increased for everybody, high earners in particular. Many regarded these as necessary to reduce the national debt; however, the effect on the economy will most likely be shrinkage, not growth, in the not-too-distant future.

In spite of the recent drop in unemployment from 8.1% to 7.5%, and the rapid rise of the stock market to new high, the economy lacks the robustness needed to grow on its own, i.e. without unusual stimulus of some sort. That has to be made up with other components of GDP, notably consumer spending or a reversal in the trade deficit. As we have noted in previous articles, it would take a spending spree, fueled by borrowing, on the magnitude as that seen in the mid-‘90’s for the kind of growth that we truly need to materialize. The huge overhang of the as-yet unimplemented provisions of ObamaCare and the ever increasing number of baby boomers entering retirement indicates that the pressure for a pretty serious storm seems to be brewing on the horizon. In other words, the Fed’s actions in the next few months leave us with a potential of a huge impact on all of us, even if we don’t regard ourselves as big investors. This seems to be particularly true if we hold too strongly to one set of beliefs about the market and economy (either that it is bound to keep going up or that it is bound to have a correction).

There is increasing evidence that we all need to morph our market risk assessments into economic policy risk assessments. By that, I mean to say that in the past, the Fed’s actions mattered to you and me much less than they will in the future. Our investment policies should be determined in large measure on whether we think that the Fed (and other policy makers around the world) will adopt the right policies and that those policies will be effective in getting economies growing again.

At the risk of over-simplification, you should become more aggressive if you believe that they will be effective and more conservative if you think they won’t. Unfortunately, the traditional monetary and fiscal policies are not likely to be enough, so what we really need to be looking for are new and innovative control measures. Disappointingly, those have not appeared in the recent Fed pronouncements.

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The Fed’s actions in the next few months have the potential of a huge impact on all of us

Scott Neal is the president of D. Scott Neal, Inc., a fee-only financial advisory firm with offices in Lexington and Louisville and the ability to serve clients anywhere. Questions and comments can be addressed to him via email at scott@dsneal.com or by calling 1-800-344-9098.