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Is the Fed Doing the Right Thing?

January 28th, 2013

by Mark Oelschlager

of Oak Associates Funds

After a strong 2012, the stock market is off to a good start in 2013, rising more than 5% so far in January and currently riding an eight-day winning streak (the longest since 2004). Encouraging economic data has a lot to do with this. Unemployment claims are at a 5-year low, home sales and prices are up, and consumer credit and retail sales are growing. Research firm ISI says that the current level of unemployment claims is consistent with 4% real GDP growth for the first quarter, which would be an acceleration from the sluggish growth of recent years. In concert with this economic strength, junk bond yields have plummeted, generally a sign that investors are not worried about credit risk. Things look much the same globally. In Europe there are pockets of strength, and China is picking up.

2012 was a remarkable year in that if you asked the average guy on the street, he had no idea how well the stock market did (the S&P 500 returned 16%), in part because the headlines were so negative. The S&P 500 has not quite returned to its all-time high from 2007, but the broader Wilshire index has, indicating that the average stock has regained its old high.

The run in stocks has been helped in large part by a global easing cycle by central banks, which has not only boosted economies but increased liquidity in capital markets. The old saying “Don’t fight the Fed” has once again proven accurate.

The Fed has taken a lot of criticism over the past couple years as it has continued its policy of purchasing Treasury and mortgage bonds in order to provide liquidity and keep interest rates low. Critics point out that this is uncharted territory and that the longer this goes on, the more difficult it will be to unwind. As a result of this policy, the monetary base, which grew steadily for decades, has exploded, roughly tripling in the last few years. The reason this unprecedented expansion has not led to inflation is that the money has not made it into the banking system and hence the money supply. Why this is the case is up for debate, but the bottom line is that it is keeping the velocity of money – the rate at which a dollar moves through the economy – low, and therefore inflation has remained subdued. But there is concern that, once the economy reestablishes itself at an acceptable rate of growth, the Fed may not be able to withdraw the liquidity in time to prevent it from making it into the money supply and creating higher – or perhaps even runaway - inflation. Many may not realize it, but in order to carry out its quantitative easing, the Fed literally creates money out of thin air. Effectively, though not literally, it prints dollars and then uses them to purchase securities. This money printing has not only led to tremendous expansion of the monetary base, but also of the Fed’s balance sheet, which leads to another issue.

With all its bond buying, the Fed has helped to keep interest rates low, but the result is that it now holds immense quantities of debt securities. In fact, the Fed’s portfolio is so large that in 2012, mainly though interest payments, the holdings generated a profit of $89 billion. Not $89 million. $89 billion! This profit went directly to the US Treasury, and it put a dent in the nation’s budget deficit. So, to recap, the Fed purchases securities (largely US Treasury bonds), thereby essentially serving as our nation’s creditor, and remits the interest back to the Treasury, so that its (Treasury’s) net borrowing cost is zero. Brilliant! Sounds like a free lunch. But we know that free lunches don’t exist.

Leaving aside the potentially dangerous incentives and precedents this arrangement creates, it is worth pointing out that eventually all these securities will need to be sold, when the Fed determines that it wants to start withdrawing liquidity from the system. Presumably this will be done at a time when the economy is on sound footing and/or inflation expectations are rising. In either case, this would likely be accompanied by a rising interest rate environment, which would mean that the Fed would be selling these securities for less than it paid. And with the value of these securities reduced, there is a question about whether the Fed would have enough to mop up the liquidity that it injected. In addition, this large-scale selling would exacerbate the rise in interest rates, possibly shocking the economy.

For all these reasons, there have been a lot of critics of the Fed’s strategy. But there are also those that support its policies. The Fed’s rationale for its current policy is that in the wake of the financial crisis, deleveraging and lack of aggregate demand necessitated unusual counteractive measures. Chairman Ben Bernanke studied the Great Depression extensively and is of the belief that it would have been handled better with looser monetary policy. He is also very much aware of the deflationary spiral Japan has been mired in for over two decades, possibly exacerbated by monetary policy that was too tight. By keeping short-term interest rates at zero and continuing its asset purchases, the Fed is doing all it can to avoid repeats of these scenarios.

The Fed recently explicitly stated for the first time that its course of policy would be directly influenced by the unemployment rate; when the rate gets down to an acceptable level, it will begin tightening. In addition, the Fed has hinted that it is specifically targeting asset prices (trying to boost them) in order to make people feel wealthier, prompting them to go out and spend. This is all a bit unsettling, as it feels like the Fed is trying to manipulate the markets.

There are a lot of strong opinions on both sides of this debate, but we fall closer to the middle, as each side of the debate appears to have some merit. We are uncomfortable with how far the Fed has taken some of its policies, but we also recognize that these are unusual times. One thing that seems relatively certain is that long-term interest rates will eventually rise from the historically low levels of today, decimating bond prices, which is why we have been warning people against holding bonds, despite their perceived safety.

Empirical Research Partners tells us that from 2008 through 2012, $1.1 trillion (yes, trillion) was withdrawn by retail and institutional investors from active managers of domestic equities. This is a staggering sum. Much of this money went into bonds. In that same five-year period, nearly half the total money in bond mutual funds flowed in during that time. As a percentage of average assets, this rate of bondinflow s exceeded the rate of fund flows into equity mutual funds in the late 1990s. As we have said before, the public’s track record as a reverse barometer for asset allocation is outstanding, and we expect this time to be no different, particularly with the prevailing gap between earnings yields on stocks and yield to maturity on bonds. Given the strong recent run of stocks and the elevated sentiment, we may be due for a short-term pullback, but the long-term fundamentals remain appealing.

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