Fed Not Likely to Alter Easy-Money Policies Any Time Soon

USA-FED

The years-long tightrope walk performed by the Federal Reserve that attempts to balance its extremely loose fiscal policy with certain economic realities -- namely, inflation and a ballooning stock market -- is growing more precarious by the month.

On Tuesday the Fed released its minutes from last month’s meeting of the Federal Open Market Committee (FOMC), which sets most U.S. fiscal policy, and the notes show growing dissension with tying the Fed’s easy money strategy to specific targets such as the unemployment rate.

But inflation hawks hoping the Fed will start raising interest rates from their historically low range of 0-0.25%, dropped there in December 2008 during the worst of the recent financial crisis, shouldn’t hold their breath.

Stock markets wouldn't be at near record levels “without the certainty that the Fed would be pumping $85 billion a month into the system.”

- Peter Tchir, TF Market Advisors

The Fed minutes reveal growing discomfort with quantitative easing, the Fed bond buying program that has swelled the Fed’s balance sheet to an unprecedented $3.1 trillion from less than $1 trillion in mid-2008. Currently, the Fed is pumping $85 billion each month into the economy through the purchase of U.S. Treasuries and mortgage backed securities.

The debate over slowing that flow of cash is likely months away from being resolved. Meanwhile, the interest rate debate hasn’t even begun.

“The metrics of 6.5% unemployment and 2.5% inflation are unchanged as barometers for eventual interest rate hikes, which are different from when and how the Fed will wind down its QE efforts,” said Greg McBride, senior financial analyst for Bankrate.com

Here’s some background: the Fed’s setting of interest rates has always been tied to inflation because low interest rates promote lending. Lots of lending pumps money into the economy which raises demand for goods and that pushes prices higher, causing inflation.

After much debate the Fed decided in December to tie interest rates not only to inflation but also to the unemployment rate. The Fed said it won’t consider raising interest rates until unemployment hits or falls below 6.5%, a far cry from the 7.9% recorded in January.

The Fed had previously all but promised not to raise interest rates at least until mid-2014 or unless economic conditions improved dramatically, and that hasn’t happened.

The Fed’s target rate for inflation tied to unemployment is 2.5%, meaning if inflation surges above that figure the Fed will consider raising interest rates. But inflation, as it’s interpreted by the Fed (an interpretation that has its detractors because it doesn’t take into account rising food or energy prices) has remained well below that figure.

Fed Inflation Hawks Outnumbered

The problem for the inflation hawks, or those that believe a policy of 0-0.25% interest rates and pumping $3.1 trillion into the economy in a four-and-a-half year span will ultimately lead to runaway inflation, is that the Fed is currently led by inflation doves, or those who believe easy money is the quickest path to recovery.

Fed hawks, like Richmond Fed President Jeffrey Lacker, a long-time dissenter of the easy-money strategies, are outnumbered and outleveraged by more powerful FOMC members such as Fed Chief Ben Bernanke and fellow easy-money proponent Fed Vice-Chair Janet Yellen.

Close Fed observers have noted the importance attached to the Fed simply making public the dissent over pulling back on its bond buying program, let alone actually altering the program or raising interest rates.

They note how negatively stock markets reacted when the Fed even hinted that the Fed’s primary “pump priming” strategy -- as detractors refer to quantitative easing, could be drawing to a close.

On Tuesday, after the release of the FOMC minutes hinting at a tightening of monetary policy, the Dow Jones Industrial Average fell more than 100 points and it continued to fall on Thursday, down more than 85 points late in the trading day. Stocks have been surging in recent months, mostly on confidence that the Fed will continue its easy money policies well into the future.

Peter Tchir, founder of TF market advisors in Connecticut, said stocks wouldn’t be at their near historically high levels “without the certainty that the Fed would be pumping $85 billion a month into the system.”

“Start ratcheting that number down and risk assets (stocks) will struggle,” he said.

In other words, imagine what would happen to the stock markets if the Fed announced it was canceling its bond buying programs and raising interest rates.

The Fed isn’t supposed to concern itself with either stock markets or politics, but many Fed critics are openly skeptical of those ideals. They argue the Fed – and the Obama administration -- fears a dramatic market downturn and what that would mean to consumer confidence and the broader economy.

Low Interest Rates Slashing Household Incomes?

Be that as it may, in addition to the threat of rising inflation there’s another quantifiable reason many economists are calling for the Fed to raise interest rates sooner rather than later.

This argument holds that the combined strategies of historically low interest rates for over four years -- and with no end in sight -- as well as bond buying programs designed specifically to push long-term rates such as mortgages lower are shrinking household incomes and forcing consumers to cut back on spending.

That’s bad news given that consumer spending accounts for 70% of the economy.

Economists have noted that many U.S. households hold more interest-bearing assets such as savings accounts, money market funds and certificates of deposit than interest-paying liabilities such as mortgages. The Fed's policies that have kept interest rates low hurt those households because those interest-bearing accounts aren’t earning any money and haven’t for over four years.

At the same time many of those same households hold fixed-rate mortgages, which aren't impacted by shifting Fed policies unless the borrower decides to refinance, a difficult option given that the recent precipitous decline in home values has left many homeowners underwater on their mortgages and unable to refinance.

Raising interest rates, according to supporters of this strategy, would potentially increase many household incomes, allowing those homeowners to spend more, ultimately driving up demand for goods, generating jobs and promoting economic growth.

But once again, don’t hold your breath.