All eyes on the Fed

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By Viktoria Palushaj

Speaking to a committee of U.S. Congressmen last month, Ben Bernanke announced that years of ultra-low interest rates may soon be over. The Federal Reserve, arguably the most powerful banking system in the world, is now considering when, no longer if, it wants to relax the pace at which it buys mortgage-backed securities and Treasury bonds each month. The current bond-buying program (QE3) is the central bank’s third and most aggressive attempt since 2008 at boosting U.S. economic growth and employment via large-scale asset purchases.

A growing legion of Fed members favor dialing back on QE3 sometime later this year, earlier than previously expected. Although Bernanke himself seems very hesitant and admits that premature tightening – before unemployment reaches 6.5 percent and annual inflation runs over 2.5 percent – could interfere with the recovery, it has now become a possibility; though his comments, like others from the Fed, were typically vague and left for public interpretation.

Investors have certainly become more interested in central bank policy in recent years. What was once considered a boring rate-setting committee now holds incredible influence over market behavior, opinions, and even demeanor. The reason for this is trifold. One, in promoting greater trust through transparency, members of the Fed have strategically chosen to familiarize themselves to the public by holding more press conferences, releasing the minutes of every meeting, and allowing for open disagreement amongst Fed members on key policy issues. Two, following the aftermath of the Great Recession and years of sluggish growth, the Fed is now the only major policymaking institution in the U.S. – the other being the government – that is actually trying to navigate the economic recovery. And because of that, three, it is burdened with greater responsibility and attention in meeting its objectives.

Unfortunately, the U.S. government itself was clearly not spending enough to help revive economic growth, so the Fed became bold with its asset purchases to make up for it. Then, the U.S. government stopped spending on stimulus entirely, encouraging the Fed to become even bolder with bond buying to overly compensate. Later, the U.S. government took a counter-stimulative step as it began actually cutting expenses, encouraging the Fed to again become more aggressive in its policy efforts. This has led to where we are now – an artificially inflated stock market supported by a controversial central bank and little else. The Fed’s loose monetary policies have maxed out their economic potential. Record low interest rates have incentivized consumer spending, home buying, and hiring as much they can. And the “wealth effect” hypothesis, whereby an increased perception of wealth leads to greater spending, and greater spending in turn stimulates economic activity, has had a more limited impact on the economy than it did in previous recoveries.

As witnessed by market movements since the Fed’s announcement, stock investors seem to want the stimulus to stay put.  What else could explain markets reacting positively to the release of weak jobs data, like the latest from the Department of Labor which showed the unemployment rate rising to 7.6 percent in May? Moreover, what else would explain stocks advancing when first quarter growth figures were revised downward? Or likewise, why a reported contraction in manufacturing activity last month – the largest in four years – led share prices higher? Simply, bad news is good news to investors because it reinforces the continuation of the Fed’s accommodative policies – allowing market participants to maximize gains, however short-sighted they may be. Investor sentiment has been far from rational, creating the havoc apparent today, and importantly causing markets to lose their meaning as leading indicators of the economy.

Ultimately, the reason why the Fed should stay committed to its stimulus is our current reality, not market behavior.  Real economic indicators still portray a fragile picture of the U.S. economy.  No one any longer expects (or even mentions) the government – lacking in urgency, understanding, and bipartisanship – to provide stimulus, though fiscal policy would more directly impact consumer spending decisions and economic growth. The Fed must continue to make up for poor government by buying more bonds to further exhaust the wealth effect.  At the very least, these efforts can help maintain the sliver of economic momentum that has been gained.

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