The Fed and The Fiscal Cliff
By Evan Schnidman
December 13, 2012
President Obama and Speaker Boehner are Thelma and Louise getting ready to drive the car off the cliff with the U.S. public locked in the trunk. While the Fed may not have the power to hit the breaks for them, they could simply refuse to fill the car with gas. Instead, the FOMC decided today to top off the tank and sup-up the engine in hopes that the President can floor it to clear the ravine. The trouble is, just a couple hours after the FOMC announced this topping off, Ben Bernanke gave a press conference in which he pointed out that the laws of physics (or in this case, economics) make it simply impossible to clear the ravine, even with the Fed’s help.
The FOMC announced today that it would be expanding asset purchases by $45 billion per month to offset the conclusion of Operation Twist. Although I was not surprised by this policy choice, I would be lying if I said I wasn’t disappointed. As regular readers will note, I am not particularly hawkish, but I saw today as an opportunity for the Committee to make a statement that the Fed (and monetary policy in general) can only do so much to help the economy in the face of catastrophic fiscal policy. In effect, this is the statement the Bank of England made last week (although for different reasons) and it is precisely what Chairman Bernanke articulated in his press conference.
While I do not subscribe to the belief that the Fed is “out of bullets,” I am certain that adding more money to an already cash-rich system has diminishing returns and significant downside risk when it comes to managing future inflationary pressure. However, if the rate at which money is moving through the system (velocity of money) remains as slow as it has been, these inflationary pressures are a long way off. Fed policymakers seem to be counting on the fact that people and businesses will continue deleveraging and that money will not begin moving through the system more rapidly. Without this assumption, Fed inflation projections would be significantly higher.
Given that policymakers seem to be assuming away any chance that money will return to normal, pre-crisis velocity, what is it that they intend to accomplish with this extra cash in the system? The answer has little to do with the extra cash and more to do with maintaining extremely low borrowing costs. Partisan commentators are quick to note that these low borrowing costs benefit a government addicted to deficit spending (we went through this exact scenario in the 1940s and it resulted in 14% inflation in 1947), but these low borrowing costs also benefit businesses and municipalities seeking to make capital improvements. The trouble is that these potential borrowers are the same ones who are still actively deleveraging, so the primary beneficiary does seem to be the federal government. Essentially, the Fed continues to enable dangerous fiscal habits (both high spending and low revenue) in hopes that elected officials will magically see the light and end their nationally destructive behavior. The trouble is, our political system makes it almost impossible for elected officials to kick bad habits and keep their job.
In addition to the increase in asset purchases, the FOMC also announced a change to its forward guidance today. Instead of saying that interest rates would rise in mid-2015, the FOMC used their own projections to say the same thing with unemployment and inflation thresholds. While most commentators expected this change down the road, few expected to see the policy altered so soon. Although I am among the few who expected to see this policy adopted right away (although I suspected January over December), I have also noted that target based guidance is not without significant problems. Chief among these problems is the arbitrary and non-representative formulas used to compute official unemployment and inflation rates which will now play an even more prominent role in Fed policy. This means that investors will need to watch employment and inflation figures closer than ever.
Those investors who were banking on an additional $45 billion each month probably need to rethink their strategy. While the money is likely to continue coming from the Fed, as Chairman Bernanke pointed out, it is not going to solve our larger problems. The truth is that taxes are going up next year regardless of whether we avert the fiscal cliff or careen off of it. The amounts will differ depending on the deal that is struck, but don’t let the Fed or the usual Christmas rally fool you, smart investors are selling off now to avoid increased capital gains taxes next year. This strategy is likely to overwhelm any seasonal or Fed-bought good will and drag down the markets until year-end.
(c) Fed Playbook