So far on this blog, I have not posted a lot of articles or written about macroeconomic policy, particularly Federal Reserve policy. Today will be the start, as I intend to post more about Fed policy, inflation, and how inflation can impact an investor's decisions.
When I was an economics major in college, I learned all about the Federal Reserve's mandate and the Humphrey-Hawkins Act. The Humphrey-Hawkins charges the Fed with two major policy mandates. The first mandate is a stable price level. The second mandate is full employment, or a low unemployment rate that does not cause inflation. Recently, with quantitative easing, creating a wealth effect appears to be a new mandate.
Most of you have probably heard of quantitative easing (QE), but what exactly is QE? QE is the Federal Reserve purchasing medium- to long-term Treasury bonds with the goal that interest rates will remain low. The goal of QE is to create a wealth effect in riskier assets (i.e. equities, real estate, etc.) The wealth effect will be a positive for the investor class, which should then lead to broader economy. The problem the Federal Reserve now faces is long-term interest rates have risen, and commodity prices have risen. The side effects of QE have created a wealth effect for upper income earners and investors, while creating a poverty effect for lower income earners because of rising commodity prices. So, does the emperor have any clothes? The emperor might still have clothes, but he is getting caught with his pants down!
A CNBC blog, NetNet, had an interesting article titled, "Is the Fed's Real Target 1,755 for the S&P?" The article highlights the corner the Federal Reserve has backed itself into points that the only way to get out is higher asset prices. It tries to answer the question: do rising stocks lead to lower unemployment, or does lower unemployment lead to rising stocks? Although the correlation is not strong (somewhere in the 28% range), the correlation points to higher stock prices leading to lower unemployment. Considering the Federal Reserve has expanded its balance sheet by $2 trillion and unemployment has actually gone up, what are implications for QE3, QE4 or QE5? As the article points out:
....If the economy does get to Fed Chairman Ben Bernanke’s target of 8 percent unemployment by 2012, that would mean the Standard & Poor’s 500 would have to rise to 1,755—a stunning 35 percent gain from current levels and beyond even the already-bullish prognostications for this year.
The problem for investors is there is no real way to determine the true effects of QE. One indicator is to look at the US Treasury market, and the twos-tens spread. The twos-tens spread is the difference in yield between a ten-year Treasury and two-year Treasury. Because the Federal Reserve is buying so much debt around the ten-year space of the yield curve, it creates a ceiling of how much rates can actually rise. The market will only truly understand when QE2 is stopped in mid-year 2011.
Dick Fisher, president of the Dallas Federal Reserve and an inflation hawk, has stated he would no longer support QE after QE2 ends. He compared the program to a fait accompli. In addition, he stated he would not support it considering the improvement in the overall economy:
You can never say never, but I cannot imagine a convincing argument for further quantitative easing after this round, given what is developing now in the economy...
Stay posted!
Is the Fed's Real Target 1,755 for the S&P? (click here)
Dallas Fed's Fisher Says He Won't Support Further Asset Buying After June (click here)
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