The Fed’s Unbalanced Decision: Stockholders Win, Bondholders Lose

Thursday, January 27, 2011

The Federal Reserve Open Market Committee decided to maintain the status quo (option #1 in the previous article, “Forecast for Bondholders: How the Fed’s Dilemma Will Affect You”).

What does this decision mean for investors?

Stockholders get improved opportunity

The beneficiaries are stockholders. Nothing promotes growth quite like easy money. It’s the tide that can lift all boats.

That’s the Fed’s hope: That more money at very low rates will foster growth – and employment (the Fed’s second mandate) as businesses succeed.

Bondholders get increased risk

The Fed’s focus on growth means:

  • Resources will become pricier (as we are seeing with commodities), meaning…
  • Prices of produced goods will go up (something we are beginning to see), and…
  • Asset values will rise (particularly stocks), increasing wealth and confidence

This growth/price cycle means bondholders are left to worry about increased inflation forecasts and  bond price declines.

Wednesday’s market could be a model for bondholders’ fate

Prior to the Fed’s statement, better-than-expected new home sales were reported. Result: Stocks up, bonds down.

With bondholders around the world getting anxious about inflation, good news is likely to hit bond prices negatively.

A final note: Why Ben Bernanke’s Fed looks like it’s making a mistake

Is the Fed really extending its easy money policy too long? Yes, based on history, as shown and described in the graph. There could be negative repercussions eventually, but it is too early to guess at their likelihood.

Note: This busy graph explains the relationship between Fed policy and bank lending, each capable of expanding and shrinking the US money supply. The previous two recessions show Alan Greenspan’s Fed conducting a balanced approach: Turning off easy money as bank lending started growing. However, Ben Bernanke’s Fed is not adjusting to the improving bank lending picture. By saying easy money will be kept “exceptionally” low for an “extended” period, the FOMC members have committed to the policy even before they see what the near future has in store.

So… The Fed’s promise to keep its exceptionally easy money policy for an extended period produces an unbalanced result. It increases stockholders’ growth opportunity  and raises bondholders’ inflation risk.

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