Tuesday, August 9, 2011

The Federal Reserve's Most Dangerous Game

The Fed announcement today that it would hold short term rates down until mid-2013 represents the agency's farthest reach in a very dangerous game. This policy will tolerate a bit more inflation than the Fed has acknowledged it will accept. At the same time, it guarantees that savers will get a negative yield on their short term holdings, net of inflation. What is the Fed doing?

Committing to hold short term rates at zero for two years won't do much to stimulate the economy. Rates have been effectively zero since the end of 2008, and look where we are now? Mired in stagnation. Corporations hold mountains of cash, so promising them ultra low borrowing costs won't make them borrow more. Consumers have been strangled by credit card interest rates that rose even as interbank borrowing costs evaporated. Perhaps consumer credit rates will rise some more.

What the Fed's announcement does is attempt to support stock prices. The Fed is promising to punish any and all investors who have the temerity to hold cash. It wants capital to move into risk assets and prevent the stock market from tanking. Momentarily, its tack seems to have worked.

But ultra low short term rates don't change the perverse risk-reward dynamic that has been punishing stock prices of late. With the Fed delivering more moral hazard, bug-eyed Tea Partiers and shrill liberals have less incentive to compromise than even a day ago. When 401(k) losses were exponentially increasing the critical e-mail traffic streaming into Congressional offices, the incentives for legislators to be constructive and productive were rising. The Fed has help them slip off the hook and get back onto the bully (pun intended) pulpit. Expect renewed political dysfunction.

Ultra low short term rates also do nothing to usher the EU toward an effective resolution of its debt problems. Today's announcement is just more of a central bank dumping corn syrup on the financial system. Asset values get a sugar high. Much of the actual downside risk in today's financial markets comes from the EU. The Fed's announcement only eases the pressure on the EU for meaningful reform.

Governments can't win when they try to artificially support asset values over any length of time. All the King's horses and all the King's men haven't saved the real estate market, which keeps edging lower. Farther back, in the 1990s, the British pound was blown out of the EU currency "snake" when the U.K. government tried to maintain it at a higher value than fundamentals gave it. The Fed is putting its credibility on the line, in a way where it has limited upside potential and buckets of downside potential. Five years from now, we might be saying that today, the Fed ventured a bridge too far.

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