The Fed’s QE2 Decision – Let’s Hope It Includes an Exit Strategy

Tuesday, October 19, 2010

Fed watching is in high gear, looking for signs that the Federal Reserve will initiate “Quantitative Easing 2” (QE2): Buying more bonds to keep interest rates low, foster economic growth and boost employment. Then there is the widespread discussion of how the news – whatever the decision – will affect the bond and stock markets.

Missing from most of what we hear and read is the more important question: When is the Fed going to exit the stage?

Here’s why that question is so important…

The Federal Reserve plays an important role in times of duress when the financial system ceases to work well. It steps in to help restore order and prevent serious, longer-lasting damage. In late 2008/early 2009 they performed that task admirably. Yes, the actual steps taken can be debated, but their presence and actions accomplished the goals.

However, we are now long past that critical time. The financial system is functioning well with ample money available in key areas. Even high risk borrowing and lending is back.

So, why is the Federal Reserve board still sitting in the driver’s seat?

Because the members changed their mandate. Now they’re trying to use easy money to pump up the economy and spur hiring.

Why is that wrong?

The Federal Reserve board members should know that not only is that not their role, but also history has shown they cannot accomplish it with easy money. The fact that they’re attempting to do so points up these possible flaws in their thinking:

  • Ignorance – That they may, in fact, not know. I used to think this was low probability until the Vice Chair’s recent speech. See “Bondholder Alert: Disconcerting News from the Federal Reserve” (October 13).
  • Hubris – They believe they are more capable than previous Federal Reserve Boards (It happens – even Alan Greenspan now admits he erroneously thought the 1990s Wall Street participants were more capable – and less greedy – than those in earlier decades)
  • Political pressure – They are succumbing to appeals within the government to do something
  • Innovator trap – They believe that they “created” today’s better markets, so they need to stay involved (remember that they used to describe the recovery – their baby – as “fragile”)
  • Myopia – They are so focused on a few goals and measures that they don’t see the damage being done elsewhere

What’s the harm in the Fed staying around?

Because their actions are abnormal – i.e., not market-determined. In today’s markets, the Fed is maintaining abnormally low short-term interest rates.

But isn’t that helping banks, corporations, governments and consumers (think homebuyers)?

Sure, but no abnormal action produces only winners (unless viewed myopically). Savers and income investors are the ones funding this largess – not the Fed. And, by depriving them of a fair and equitable return on their savings, the Fed has seriously hurt them.

Worse, the Fed has played this role so long that these people have been driven to look elsewhere for income. Once in safe savings accounts, CDs and money market funds, many savers/investors are now in longer maturity and lower quality (even junk) securities (where Wall Street extracts a fee from the income for helping them pick out the stuff).

If the Fed had to include these savers/investors in its congressional reports, it would have had a failing grade starting over a year ago. I doubt it would/could have continued its low rate policy this long.

As investors, what should we take away from this analysis?

First, realize that if the Fed goes ahead with QE2, far from being an all around good thing, it is an extension of Fed interference in the normal workings of the financial system. Moreover, as in the past, the attempt will likely fail to boost real economic growth and employment. Then, there is that inflation thing…

Second, welcome the decision not to go ahead with QE2. Regardless of their rationale, it would be a positive sign that the Fed is finally exiting the stage.

So… This is a time to wait and observe, then act according to which route the Fed takes. I believe better economic growth and investment returns will come from the Fed bowing out. However, a continued presence will offer investment opportunities as well.

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