The Tough Situation of the Fed

Ben Bernanke is certainly in a tough position.  It’s often cited that the Fed has a tough balancing act with the dual mandates of promoting ‘full employment’ and ‘low, steady rates of inflation’.  Currently, Bernanke is under intense political pressure to do more for employment, when there isn’t really a lot he can do.  Keep in mind that the only thing that the Federal Reserve can influence is interest rates, which are already at record lows. 

Employment is affected by many factors outside of the Fed’s control – such as government regulations, market interventions, taxes & subsidies, and a stable/predictable or unstable/unpredictable environment for investment.  Low interest rates alone simply can’t fix all these problems.

Those clamoring for action from the Fed are looking for them to do one of two things: 

First, they can cut the rates they pay banks for holding money from 0.25% to zero.  However, the banks must hold secure, liquid cash regardless so this will partly act as another tax on banks, which won’t help them raise a safe margin of capital, and partly send more of their capital their few other alternatives such as short-duration treasuries, which are already at near-zero yields. 

Second, the Fed can expand its balance sheet once again.  This lowers rates by reducing the amount of investment alternatives to the same pool of money from investors, forcing them to bid up prices and accept lower yields.  A good example of this is the recent tripling of the Fed balance sheet into mortgage-backed securities, the debt of Fannie Mae and Freddie Mac, and long-duration US government bonds.  This has pushed the spreads between mortgage rates and the 10-year treasury to record lows, and has flattened the yield curve considerably for US treasuries, which now pay less than 3% for a 10-year note and near 4% for a 30-year bond.  This in turn lowers costs for business – particularly large companies that can issue bonds on the market – but the effect on the amount that banks put in riskier investments, such as lending to small businesses which create jobs, is somewhat limited.

Either action by the Fed in lowering interest rates has 2 major side effects:  First, lower rates make it much more difficult for pension funds, mutual funds, and 401k’s generate the returns they need for retirees.  This means public-sector pensions are under-funded, so they require and take more private-sector money, while private-sector 401k’s are simply crushed, forcing employees to delay retirement plans.  Second, additional action could actually stoke inflation fears enough to raise interest rates, which will harm businesses.  If investors fear that the government is simply monetizing the debt, they will dump US holdings of all sorts in favor of foreign securities and hedges such as gold and commodities.  This would have the dual affect of raising prices (another tax on consumers) and raising interest rates (another tax on businesses which create jobs). 

I’ll end this by saying that despite the lack of options for the Fed, I have incredible respect for Ben Bernanke and I think he’s doing the best anyone can in the current political environment.  We have an activist congress and administration which uses all their powers to crush anyone in a leading position who disagrees with their policies (as with Wellpoint in their disagreements on Obamacare), and wants to increase its influence over the Fed.  In this environment I find it reassuring that Bernanke can suggest that the US government find an ‘exit strategy’ for their stimulus spending, without inspiring a political backlash.  US politicians in general are notoriously economically-challenged and we need someone like Bernanke at the helm who understands the risks we are facing, can reassure the markets, and at the same time navigate the tough political waters.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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