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 November 2010 Short-Term Solution, Long-Term Problem The Fed is Ready to Fight Deflation, but What About the Long-Term Effects?
But so far all efforts have failed -- some spectacularly:
So understandably the government now more than ever wants to take action to push the economy out of its ongoing slump. But after so many failures, can it?
The Fed to the Rescue But under the leadership of Ben Bernanke -- a student of the 1930s's Great Depression -- the Fed has been sending signals it now stands ready to pump more liquidity into the economy. Mr. Bernanke believes the tight money policy of the mid-1930s allowed deflation to take hold and ultimately prolong the Depression. By acting now, the Fed can head this off and hopefully, get the economy back on the path to growth.
That may be, but the proposed strategy does not come without risks. One traditionally thinks of the Fed as focused on fighting inflation and indeed, that's what it's done for the past seventy years. But now with economic activity crawling, the central bankers actually believe inflation is too low. That's right, too low. For months it's remained below the Fed's unofficial annual target of 2%. That's why deflation is once again a concern. Rather than combating inflation, the Fed actually intends to create it by what's been called "quantitative easing". The less favorable term is "printing money." Essentially this is achieved by the Fed purchasing Treasury securities on the open market while leaving billions of dollars in their place. The risk is obvious: Miscalculate and the inflation genie is out of the bottle. .
Upside Down World Equity investors are welcoming it, too. For many, it's no so much that easy money will help move the economy but rather that as long as the Fed's easing, it isn't tightening. Ever since the Fed allowed the earlier security purchase program to die out in March, stock investors have feared monetary policy would tighten too quickly, choking off all that remained of the recovery. So if the Fed is willing to be accommodative, that's one less thing to worry about. And that's good, because there are plenty of other things to worry about. The falling dollar is starting to appear on many investors' radars. Ironically, it's part of the fallout of an easy money policy. As more dollars flood the market, the amount of goods remains relatively stable. As a result, it takes more dollars to buy an ounce of gold, a gallon of gas, and a pound of cotton (which, by the way, recently hit its highest nominal price since 1870). Not only are more dollars flowing out of the U.S. for commodities, they're also heading out for investment. Foreign economies, particularly those in emerging markets, are faring much better than the U.S. Domestic investors willing to invest abroad not only receive the benefits of rapidly appreciating shares, they also benefit from the favorable exchange rate when foreign profits are translated into weaker dollars. Even in developed countries, the dollar is weak. The euro staged a strong recovery from early year lows while the Canadian dollar is at parity with its U.S. counterpart. The mid-term elections have come and gone, yet U.S. stocks continue to labor under a cloud of political uncertainty. The lame-duck Congress must still decide where the Bush tax cuts will be extended or if they'll become the Obama tax increases. Regardless, after the past two years profligate spending, there's a general perception taxes will be on the rise in 2011.
Higher taxes in a struggling economy -- the very thing scholars of the Great Depression wish to avoid -- could easily deal a major setback to the weak recovery. Because of this uncertainty, U.S. businesses are reluctant to spend or invest, choosing instead to hold onto their capital to weather the potential storm from higher taxes and Obamacare mandates. Given the remarkable runs in the foreign markets and the lingering uncertainty here at home, wise equity investors have looked -- and will probably continue to look -- elsewhere. Yet even this can't go on much longer. Without the economic engine of the U.S. driving demand for foreign goods, global growth will eventually feel the impact. After the gains already experienced this year, it's hard to believe even foreign stocks have that much further to run without the support of the U.S. consumer. Investors who haven't already diversified abroad should be very cautious attempting to do so now.
Be Careful What You Wish For Bonds face a tough 2011 as rates will eventually have to begin moving back up to more realistic levels. On the other hand, equity investors may look forward to a more stable and productive investing environment when political and market uncertainty declines. Over the past several decades, the Fed has always had a better sense of the economy's needs than Congress. It's nice to see the Fed willing to step into the breech on behalf of the struggling economy, but it would be even better if they didn't have to resort to a dangerous short-term measure with potentially devastating long-term consequences. Although the second wave of quantitative easing was announced following the November FOMC meeting, hopefully the Fed can exercise restraint. From a longer-term perspective, this is one of those cases where less is better than more. Investors hoping they'll once again start the printing presses should be careful what they wish for -- they might just get it, and a lot of it. Search this site! Just enter you key word or words:
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ONE CAN FAULT THE GOVERNMENT for trying to jump start the sluggish economy. Growth is again slowing and unemployment continues to hover around 10%. In an election year, politicians have an increased incentive to do something -- or at least appear like they are -- so they can have something to tout while out on the campaign trail.
