The Fed: Searching for Policy in the Mirror

In assessing tough decisions, policy makers tend to weigh the cost of action versus inaction. As critical as we are of our dear policy makers, when push comes to shove, they may rise to the occasion. But what if they are not told when it’s time to act -- when it’s time to stop printing and spending trillions?

In our assessment, the voice of reason has been silenced. This poses risks to economic stability, as well as the dollar. That voice of reason is no other than the market itself.

As the Federal Reserve has become ever more engaged in micromanaging the economy, we have moved from rate cuts to emergency rate cuts to printing billions, and then trillions, to buy mortgage-backed securities and, more recently, Treasuries. Coming to the realization that talk is cheaper than action, the Fed has since switched gears and “committed” to keeping rates low, initially through mid-2013 and now through the end of 2014.

The Fed has a buzzword to describe its policy: “transparency.” Instead, you may want to call it the “fear not -- we will take care of you” policy.

There are reasons the Fed needs to signal that rates will stay low for such an extended period. A reasonable person may believe that the current monetary policy could be inflationary, and that the Fed actually wants to have inflation to bail out homeowners who are under water in their mortgages. A reasonable person may also have paid attention to Fed Chairman Ben Bernanke when he argued that raising rates too early was one of the biggest policy mistakes during the Great Depression, and that erring on the side of inflation is desirable. But “fear not -- we will take care of you” is the message. The Fed is introducing an inflation target and providing assurance that inflation won’t be a problem.

The alternative, of course, would be to conduct what we would deem sound monetary policy, so that a reasonable person wouldn’t be concerned about the risks of money printing in the first place. But that’s so yesterday. Instead, the Fed has engaged in Operation Twist, applying its firepower to lowering rates further out the yield curve (longer-term interest rates).

The Fed now owns more than 30% of all outstanding marketable US Treasuries with maturities of 6-10 years. Across the yield curve, from Treasury bills to 30-year Treasury bonds, the Fed has accumulated almost 20% of outstanding securities. These days, the Fed owns more US government debt than China.

As long as there is confidence in the Fed, its strategy may pan out, right? Maybe.

We don’t question the motives of the Fed. However, we question its ability to conduct policy when its policy makers are blindfolded. We fear that some of the most important gauges for setting policy have been taken away by the Fed itself. As if to prove the point himself, Bernanke told Congress last week that he is puzzled about incoming economic data. He cannot explain why the unemployment rate has come down quite so rapidly.

Consider the yield curve. Typically, yields provide a wealth of information about the health of the economy and inflationary pressures. As such, an important feature of the yield curve is that it can sell off if inflationary pressures pick up or investors grow concerned about long-term fiscal sustainability. With the Fed becoming ever more engaged in yield curve management further along the curve, this gauge has been taken away.

Former Fed Governor Kevin Warsh, a critic of active yield curve management, has said the Fed is looking into the mirror in conducting policy. We agree. Luckily, the folks at the Fed are some of the smartest economists around. Unfortunately, they are human and should be reminded periodically that the greatest failures in monetary history have also been made by some of the smartest economists of the time.

This is an excerpt of an article by Axel Merk available on the Merk Funds Website.