The Federal Reserve's Obligation to Support Stock Prices

The Dow Jones Industrial Average is setting a new record almost every day.  Stocks are up 10% in 2013, and the year isn't even three months old.  Since the recent closing low on Nov. 15, 2012 of 12,542.38, the Dow has risen over 15%.  Stocks are on a tear and fresh money is coming into a market that's going up at an annualized rate of 50% or more.

A principal reason for the hyperventilation in the markets is the Federal Reserve's ultra lax monetary policy.  Even though unemployment has fallen from over 10% in 2009 to 7.7% now, and the economy has resumed moderate growth, the Fed has spent the last four years swinging its scythe far and wide to cut down any positive interest rates that might sprout up.  At the same time, it has printed shiploads of money through its quantitative easing policies.  An abundance of cash, having few other alternatives, has flowed into stocks.  At this point, the market depends on the Fed to maintain and increase its accommodation.  Moral hazard abounds.  Investors have put their precious savings in stocks relying on the Fed's promise to practically give away money for a really long time.  If the market falters now, the Fed will have to step up and accommodate some more, enough to prop up stocks.  It can't allow investors to suffer a third evisceration of their portfolios in less than 15 years.  If the market stages another major downturn, investor and consumer confidence will surely collapse, sending the U.S. into another recession and putting the U.S. financial system under enormous stress. The stock market has become Too Biggest To Fail.

Of course, the Fed would deny that it has any obligation to support stock prices.  Legally speaking, that's true.  But the U.S. Treasury had no legal obligation to support Fannie Mae and Freddie Mac, yet it nationalized them in order to prevent a collapse of the financial system.  The Treasury Department had no choice, given that the market had implicitly assumed that Fannie and Freddie were federally guaranteed.  By relentlessly inflating stock prices, the Fed has put itself in a comparable position.  It has implicitly guaranteed that stocks will not suffer a major collapse. 

The Fed is already honoring its implicit guarantee.  It's stated that the most recent round of QE (call it "QE Unlimited") will go on until unemployment falls to 6.5%.  The market has risen about 10% since the Fed announced this target.  A gnawing risk of the Fed's current policy mix is inflation, and the Fed has said it will step back if inflation flares.  But the question is whether it actually will.  Having drawn investors back into stocks after the market crash of 2007-08, the Fed may hesitate to take away the punch bowl if doing so will precipitate another bear market and recession. 

 Of course, it can't leave the punch bowl at the party forever.  But, given the pickle it's currently in, it may let the party go on too long.  We are at a crossroads in the history of central banking.  If the Fed pulls off its current maneuvers and nurses the economy back to health while keeping inflation in the 2% range, it will have established the paradigm for monetary management of the economy for decades and perhaps centuries to come.  If it fails, however, central banking as we now know it will likely become a thing of the past.

Political Risks of Social Insecurity

The financial press has reported that the United States ranks 19th worldwide in the retirement security, lagging behind Slovenia, the Czech Republic and Slovakia, among other nations.  http://www.cnbc.com/id/100534205.  We're one step ahead of Britain, but well behind France and Germany.  The Scandinavian countries rank at the top, along with Switzerland, Austria, the Netherlands and tiny Luxembourg.  Even Japan, after more than two decades of economic malaise, ranks 15th, four steps higher than America.

This probably doesn't surprise many Americans, particularly those who are approaching or in retirement.  They have probably already viscerally sensed their comparative insecurity.  Herein lies great risk for politicians who would reduce America's social safety net.  Our net is modest compared to the protections offered by most of the industrialized world.  If it's cut, the pain--particularly for moderate and lower income Americans--could be pronounced.  It's one thing if your retirement benefits may not cover as many restaurant meals as you would like.  It's another if your cost of living increase is so paltry that you can't afford needed prescription medications.

That we have a fiscal imbalance is because our taxes are even lower on a comparative basis.  (See http://usatoday30.usatoday.com/money/perfi/taxes/2009-11-25-oecd25_ST_N.htm.)  America could without enormous pain pay for its current social safety net without having to borrow.  We just don't want the taxes it would take to get there. 

Many politicians in Washington sound off about cutting Social Security and Medicare benefits.  This isn't just Republicans.  President Obama has been quick to offer reductions in Social Security.  One is to change the Social Security inflation adjustment from the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) to the Personal Consumption Price Expenditures Index (PCE).  The effect of this change would to gradually erode the relative value of Social Security benefits, with the most elderly being the hardest hit over time.  Is is really a good thing to whack the most vulnerable, who may have exhausted their savings and be unable to work? 

Consciously or subconsciously, Americans know that their retirement benefits aren't great.  And many of them won't be happy with politicians who make their retirements bleaker.  If the President and the Republicans somehow reach a Grand Bargain to stabilize or even balance the budget, the political impact may surprise them.  As Republicans clumsily attempt to embrace diversity, their core of older, white Americans may abandon them if they lead the charge to cut retirement benefits.  President Obama, instead of being viewed as a latter day FDR, may end up appearing to fall into the mold of Herbert Hoover.  And the liberal left, annoyingly shrill as they can sometimes be, may end up inheriting the White House in 2016. 

Idolatry in the Financial Markets

A lot of investors, it would appear, are throwing money at increasingly esoteric investments in order to prevent inflation from eroding their capital.  Junk bonds, asset-backed securities and real estate investment trusts have become fashionable.  With the Fed waging a 24/7 scorched earth campaign against positive interest rates, risk is being embraced.  One can only hope that the end result isn't like embracing a cobra--"risk on" investing strategies aren't risk-free.

A false premise widely circulated by financial sales people and cable TV pundits is that you have to preserve your savings from the ravages of inflation.  And, certainly, over long periods of time, inflation can significantly diminish your capital.  But you can't overlook the costs and risks of trying to protect yourself from inflation.  If those risks smack down your net worth, you haven't accomplished anything except lose money and then suffer inflation's death of a thousand cuts.  There's nothing wrong with losing a little ground now and then to inflation, while saving and investing with a view to long term financial equanimity.  If you lose ground to inflation for one, two or even a few years, don't panic.  Try to position your portfolio so that you can make up the "losses" later on.  Also spend less and save more.  This will increase your net worth without requiring you to dial up the risk.

The same is true of keeping pace with market averages.  The Dow Jones Industrial Average, the S&P 500, or whatever benchmark you might follow may be convenient ways to assess the performance of money managers who want to take your savings.  But market indices don't need to be your financial goals.  If your portfolio is conservatively deployed and doesn't keep pace with the S&P 500, you haven't "lost" unless you decide you're a loser.  As long as you are saving enough for retirement, your kids' college costs, and whatever other goals you might have, it doesn't matter a rat's left ear whether or not your investment returns match one market index or another.  If your portfolio is more cautiously invested than the stocks found in an index, you won't suffer the volatility of the index.  Maybe the Dow just reached a record level (although this really isn't a record once you factor in inflation).  But looking back at what happened in 2000 and 2007 after the Dow previously reached record levels will tell you that keeping up with market indices can be a losing proposition. 

Keeping pace with inflation and with market averages are, for individual investors, false idols that they need not worship.  Building your net worth isn't a contest.  It's a process.  There are lots of ways to make your retirement years golden.  Do whatever helps you sleep at night.

No Fiscal Discipline in the Stock Market

As the federal government belly flops into sequestration, the stock market merrily rolls along.  Europe is sinking into recession, an inevitable result of its austerity and deleveraging policies.  Japan is in recession, and has pledged to worship at the altar of monetary accommodation in an effort to revive its economy.  American consumers are creeped out by continued government dysfunction, continued economic dysfunction and an increase in Social Security taxes.  Retailers are reaching for the little paper bag in the seatback on front of them.  But stocks are delirious.

Of course, it's all because Federal Reserve Chairman Ben Bernanke yesterday swore up and down that central bank accommodation is next to godliness, or something to that effect.  If the most powerful agency in the United States government promised to subsidize you indefinitely, you'd be delirious, too. 

By ignoring real world problems, and flying high on the Fed's fiat paper meth lab, the market is letting Congress off the hook.  Without someone or something twisting their arms behind their backs, the members of Congress have little or no incentive to get real and work out the nation's fiscal problems.  The stock market has the leverage to make Congress devote its full attention to a problem. In the fall of 2008, when the financial system teetered on the brink, Congress voted down a rescue package.  The market promptly nosedived, and squashed 401(k) accounts from sea to shining sea.  Constituents deluged Congressional offices with negative commentary (that's putting it mildly).  Congress immediately reversed course and enacted the TARP rescue legislation.

Today, however, fed by the Fed with printed money, the market romps.  Congress fiddles.  And the rest of us get nervous about the smell of smoke that waffles through the air.  By not holding Congress accountable, the market enables government dysfunction.  The market can be quite effective when it imposes discipline.  But an undisciplined market is scary.

Politics Keep the Economic Crises Going

We are vividly reminded today that the economic crises bedeviling the world are political in nature.  The election deadlock in Italy, with leftists likely to control one house of the Italian Parliament, and rightists and leftists apparently in  a draw in the other house, is a vote against austerity and centralization of the EU's governance. Although the political nuances differ from Greece's initial anti-austerity vote last year, the Italian election, like Greece's, signals that numerous voters have yet to learn the words of the pan-European version Kumbaya.  Another election in Italy may well be needed, or the country will be unable to stay on track to meet the EU's expectations.

In America, sequestration now seems almost a certainty.  The arbitrary cuts imposed by sequestration were supposed to be unpalatable to either party, and would therefore incentivize both parties to cut a real deal.  Fat chance of that in these days of political dysfunction.  Truth is there won't be a real deal.  That's why the Dems and Republicans kicked the can down the road when the fiscal cliff loomed and the debt ceiling threatened to descend like the Sword of Damocles.  The government right now can do little more than bring its foot back for another kick.  The one silver lining in the clouds is that the economy seems to be recovering to some degree.  The better the economy does, the lower the deficit will be.  We should hope and work for economic growth, because that is the only politically feasible solution to the budget deficit.  The federal government needs to repair and upgrade infrastructure, adopt a pro-growth immigration policy, work hard to cut the growth of health care costs (perhaps the biggest expense in future federal budgets), and work toward supporting and expanding educational opportunities while reducing the cost of education.  (Internet-based instruction may be a great way to educate at much lower expense, and should be encouraged and supported.)  The current squabbling in Washington over budget cuts and tax increases is a game of musical chairs that no one can win.  We have to take a different approach.

Keep Your Investments Simple, Because the Alternatives Could Be Worse

As reported by the New York Times (and linked through CNBC.com:  http://www.cnbc.com/id/100449551), retail investors are once again being burned by complex alternative investments.  This is an old story in the annals of investment busts.  The more complex an investment, the less likely a retail investor will understand it, and the greater the advantage an unscrupulous broker will have in foisting it on the unsuspecting.  What's troubling is that many of the victims weren't seeking a fast, speculative buck.  They were often conservative investors who were pushed by the Federal Reserve's scorched earth policy against interest rates to hunt in dark, dank thickets for elusive, ethereal positive yields.  Desperate for investment income, they fell victim to sales people saying what they wanted to hear, but maybe not what they needed to understand.

An underappreciated element of saving and investing is the need to manage risk.  Manage doesn't mean avoiding all risk, and it certainly doesn't mean seeing greater risk as the path to greater rewards.  It means understanding that risk and reward are linked, and that not getting too greedy about rewards is the way to long term success.  Some risk is reasonable, as long as you don't expose yourself to so much volatility that you grab the little paper bag in the seatback in front of you and put all your money in a mattress.  The tortoise beats the hare when it comes to investing.  Searching for quick returns is like donning wings of paraffin and flying toward the Sun.  Don't invest in anything that you don't understand--and that means having a full appreciation for every way your hmmmm can be deep fried.  Simple, steady and average are a decidedly better bet for making you comfortable in retirement than the latest in glam financial fashions.  For more, see http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.

Dow 14,000: So What?

What does Dow Jones Industrial Average at 14,000 mean?  Not much, when you consider that it's to a large degree the product of the Fed's unremitting money printing policy.  A "value" achieved through government policies, rather than market forces, has little intrinsic value.  Witness the real estate markets of 2007-08:  decades of government subsidies through the mortgage markets, tax laws and Federal Reserve monetary laxity puffed up home values until they exploded in our faces.  Comparable subsidies (like quantitative easing) and more easy Fed money can do the same to financial assets. 

Right now, retail money has started flowing into stocks again.  That's deemed by many market pros to be a sign of an impending market peak.  If you want to get in and out of the market--i.e., trade it as if it were an asset bubble--there may be some greater fools who would buy from you.  That is, if you act quickly enough.  But investor, beware.  The Fed is making an enormous bet right now:  that enough monetary stimulus will somehow revive the economy to the point that it will independently resume sustained growth and return to full employment.  That such will occur is unusually uncertain.  Aside from the fact that economic revival has been painfully slow even with all the printed money, one has the sneaking suspicion that the Fed has quietly placed a side bet that its easy money policy would push down the value of the dollar enough that America might export its way to prosperity.  But other export-centric nations are fighting back.  Japan has effectively undermined the independence of its central bank in order to push the yen down. China has stopped levitating the renminbi. And the Germans are starting to grouse audibly about the revival of the Euro.  Currency wars tend to take on the look and feel of a circular firing squad, and the major economies of the world are charging their muskets.

Maybe the Fed Won't Sell Off Its Balance Sheet

A major question overhanging the financial markets is what will the Federal Reserve do with its $3 trillion and growing balance sheet?  The conventional wisdom is that, eventually, it will have to sell off much or most of its holdings, lest the Inflation Monster come roaring out of its lair.  The specter of $1 trillion, $2 trillion or perhaps more of Treasury and mortgage-backed securities hitting the bond markets would send a shiver down the spines of many a market player.  Even a suggestion that such sales are impending could induce interest rates to pop and stocks to drop.  All the Fed's hard work to stimulate the economy could circle down the drain as rising borrowing costs smack down home purchases, consumption and corporate investment. 

To avoid such a scenario, maybe the Fed will simply not sell off its balance sheet.  In the often strange alternative universe of the Fed, where massive money printing isn't perceived as an inflationary threat until the Monster is tearing into our throats, this might make sense.  Once the Fed stops purchasing Treasury securities and other debt in the open markets, it can simply hold the assets on its balance sheet until they are paid off.  It would remit the interest and principal payments to the U.S. Treasury.  This would reduce the amount of taxes that the Treasury would need to squeeze from harried citizens, aiding their ability to consume, while lessening the threat of its balance sheet to the stability of the financial markets.  If the Fed were to sell its assets in the open markets, it would compete against private interests for capital.  If it were to hold its assets and remit the proceeds to the Treasury, more capital would be available for private investment. 

Sounds too easy?  It would be too easy if the truckloads of printed money that the Fed has dumped into the economy inflates the dollar at substantially more than today's low rate.  But the velocity of money today seems driven by little more than a three-cylinder, two-cycle engine.  The economy is hardly growing any faster.  Unless economic growth rises above the fast side of brisk, selling off the Fed's balance sheet will threaten the recovery.  The Fed may well be tempted to take advantage of today's low inflation rate, and simply hold its balance sheet until maturity.  We'll see.

Consider a House To Hedge Against Inflation

The housing market, having walloped the bejesus out of tens of millions of Americans, may seem an unlikely hedge against inflation.  But history shows that home prices tend to move up briskly during inflationary times.  During the 1940s, inflation burst out, driven first by World War II rationing and then by pent up consumer demand after the war.  Consumer prices moved up about 72%.  Census Bureau data indicates that housing prices moved from a national average of $2,938 in 1940 to $7,354 in 1950 (unadjusted for inflation).  That's an increase of 150%.

During the stagflation of the 1970s, consumer prices rose 112%.  Housing prices rose from a national average of $17,000 in 1970 to $47,200 in 1980, an increase of 178% (unadjusted for inflation).  You can find Census Bureau data on housing at https://www.census.gov/hhes/www/housing/census/historic/values.html.

The data show that housing prices rose faster than inflation during two of the most inflationary decades in the past 75 years.  Of course, the sales prices of houses don't tell the entire story.  You can't directly compare prices of housing against prices of stocks or inflation-adjusted bonds like U.S. Treasury TIPS, because housing requires periodic lawn mowings, plumbing repairs, new roofs, maintenance of HVAC systems, and replacement of dishwashers.  It's also taxed locally every year, and sometimes hit up for special assessments if the water or sewer systems need to be gussied up.  But you'd directly or indirectly bear those expenses anyway if you rented.  So owning a house and capturing the upticks in value might work out well for you during inflationary flareups. 

Why would housing be such a good inflation hedge?  Professional economists might be tempted to wheel out a wagon load of regression analyses to demonstrate their erudition.  But the simple and obvious explanation is that a hard asset with substantial utility will have significant value no matter what the paper currency is doing.  A house provides shelter, warmth, indoor plumbing, and a private place to pig out on high fat, high sugar, low nutritional value junk foods while long-term parked in front of a 124-inch TV, parboiling your brain without the neighbors seeing what a couch burrito you really are.  Market forces will adjust the paper value of that hard asset upward when the fiat currency is going haywire.

At the moment, inflation seems to be spotted about as often as the ivory-billed woodpecker.  But that doesn't mean it's extinct.  History shows that inflation can be quiescent for long periods of time, and then burst forth like an oil well blowout.  Inflationary pressures right now are doing a fan dance, often out of sight but still faintly visible in profile.  Ultimately, unless the Fed and other central banks can repeal market forces, their massive money prints and asset purchases of recent years will eventually inflate paper currencies.

 Housing, like politics, is first and foremost local.  Some markets would make mediocre investments no matter what (like areas with high unemployment).  Some types of housing, like condos, may not be ideal for inflation hedging.  Their values tend to be less stable than that of the 4-bedroom, 2 1/2 bath Colonial with the white picket fence and English sheep dog.  A house isn't a substitute for sensible investment diversification.  Stocks, TIPS and perhaps other assets might also play a role as reasonable inflation hedges in a well-diversified portfolio. 

It's hard to have confidence in housing after the free fall in prices of recent years.  But investment success can often come from buying disfavored assets.  Buying bubbly assets like bonds (especially junk bonds) isn't likely to be the epitome of financial perspicacity.  Home sweet home, be it ever so humble, may work out better if inflation rears its ugly head.

Reducing the Deficit: Should the Fed Monetize the Federal Debt?

Desperate times call for desperate measures.  We've seen yet another dysfunctional mess from the political process, and have to think expansively.

The recent fiscal cliff deal was largely a failure.  It raised taxes on most Americans, while doing virtually nothing to reduce federal spending.  While income taxes were not increased for the middle class, Social Security taxes were increased for all workers at all income levels.  The well-off (the $400,000 plus crowd) face a higher income tax rate of 39.6% (20% on qualified dividends and capital gains) and wealthy dead people now pay a 40% tax rate (instead of 35%) on the portions of their estates exceeding $5 million ($10 million for married couples).  The automatic spending cuts required by the cliff were deferred for two months (except for $24 billion in cuts that do go into effect), so spending largely continues apace.  Presumably, there will be a second face off over spending cuts when the President asks Congress to increase the debt ceiling in the next few weeks (even though the White House insists it won't negotiate over the debt ceiling).

One thing to take away from the cliff deal is that spending cuts are really hard to agree on--so hard that the Dems and Republicans simply kicked the can down the road.  But they will be even harder to agree on two months from now.  The Republicans have lost significant leverage by agreeing to tax increases now.  The tax side of the fiscal cliff has been resolved, more or less favorably to the Democrats (although some liberal Dems are still unhappy).  What incentive do the Dems, who control the Senate, now have to agree to spending cuts?  Of course, the Dems would agree to some spending cuts (the defense budget would be their target number one).  But Republicans are focused on hurting core constituencies of the Democratic Party through Social Security, Medicare and Medicaid cuts.  With the Dems having largely won on the tax issues, they have little reason to make concessions on the social safety net.  Even if the President is willing to give the Republicans some of what they want (which he seems to be), he may have a problem in the Senate, where Social Security, Medicare and Medicaid were stoutly ring-fenced and defended during the fiscal cliff talks.

Realistically speaking, we shouldn't expect our dysfunctional elected government to find grand solutions to the fiscal deficits.  Due to a variety of bad and intractable political dynamics, that simply won't happen.  We have to look elsewhere for solutions.

The next logical candidate to get the hot potato would be the Fed.  The central bank has played a central role in combating the Great Recession, not without some success.  In the course of its massive quantitative easing programs, it's accumulated a balance sheet of close to $3 trillion.  This total is likely to grow as the Fed continues to purchase debt on the open markets.  Slightly over half of the balance sheet consists of U.S. Treasury securities.  Total federal debt is about $16 trillion.  Thus, the Fed holds about 10% of all federal debt.

Why not have the Fed simply forgive some or even all of the U.S. Treasury debt it holds?  In other words, it would declare that the Treasury wouldn't be required to pay the debt.  That, by definition, would reduce the federal deficit by reducing the amount of federal debt outstanding.  And it's what happens anyway.  When the Fed receives debt payments from the Treasury (usually consisting of interest payments), it simply remits those funds back to the Treasury Dept. (except for a small amount retained to finance the Fed's budget).  Debt forgiveness by the Fed would simply expand on what happens in the ordinary course.   

Of course, such debt forgiveness would be tantamount to monetizing the debt, and has the potential to be inflationary.  But precisely what the heck do we think is going on now?  When the Fed launches repeated quantitative easing programs, with ever more asset purchases but not the tiniest hint of when, if ever, it would unwind its Brontosaurian balance sheet, it has functionally monetized the debt.  With the economy expected to be a sick puppy for years, reality is the Fed may hold a lot of its current inventory of U.S. Treasury securities until they mature.  When they mature, it will remit the principal payment it receives from the Treasury back to the Treasury (or use the funds to make more open market purchases of Treasury securities).  The federal debt has been monetized, even though no one on the government's payroll is going to admit it. 

Such debt forgiveness wouldn't fully resolve all the deficit problems.  But it could reduce the scope of the crisis, and would amount to little more than accurately accounting for what is actually going on.  If inflation flared, the Fed could suspend debt forgiveness and raise short term interest rates, combating inflation as it traditionally would.  But as long as inflation is subdued, debt forgiveness could contribute to resolving a problem that politicians clearly won't be able to solve, at least not comprehensively.

Ultimately, the best solution to the deficit problem is to boost economic growth.  Greater growth means higher employment levels and more income and corporate profits to be taxed.  If the economy were growing briskly and unemployment were around 5%, we probably wouldn't feel we have a deficit crisis.  Housing seems to be stabilizing, although its long term prospects remain clouded.  So we can't count on housing to be the engine for growth.  Measures the government could take include:  (a) rebuilding infrastructure--this is something the government has historically done well, and should do more of given the crumbling state of our infrastructure; (b) loosen up immigration restrictions for well-educated people and people who can invest substantial capital in America to create jobs--we need more innovators and entrepreneurs; (c) improve education, not by handing out loans to anyone who has a pulse and a signature (there's way too much student debt already, and it will be the next big debt bubble), but with measures to make education more efficient and inexpensive, like expanding Internet-based educational programs.  Achieving greater economic growth will take time, but it's a lot easier than trying to use the political process to agree on budget cuts.