Since 1980, the policy of the Fed has been to avoid a repeat of the “Great Inflation” that gripped the U.S. economy during the 1970s. The political pressure to improve economic conditions has been a constant for the Federal Reserve throughout its history. Effective with the Employment Act of 1946, the Fed has been assigned the objectives of “maximum employment, production and purchasing power.” In the 99 years since its creation, the Fed has been more successful in battling inflation than it has been in achieving maximum employment.
Determined to fight the weak job market and economy, on September 13, 2012, the Fed announced it would make additional agency mortgage-backed security purchases in the amount of $40 billion per month. The Fed is specifically targeting mortgages and the housing market since it believes an improving housing market will provide broad benefits to the economy and encourage hiring. Referred to as “QE3”, these purchases will have no set end date and the Fed can expand this program if the labor market does not improve. The Fed also announced that it intends to keep short-term rates near zero through mid-2015.
The Fed also plans to continue to reinvest mortgage principal payments that it receives on its investments into agency mortgage-backed securities (our sources at Metropolitan West advise that this involves between $25 billion and $30 billion per month). Agency mortgages are issued by the government-controlled entities Ginnie Mae, Fannie Mae and Freddie Mac.
In June 2012, the Fed announced it would extend Operation Twist until year-end. Under Operation Twist, the Fed is selling short-term Treasuries to buy $45 billion per month in longer-term Treasuries that mature in seven to 30 years. It has pushed down interest rates on Treasuries, or “safe assets,” and lowered the government’s borrowing costs on our record debt. It has done so at the expense of those living on interest income.
In the chart below we show the impact of Operation Twist on interest rates. You can trace the Fed’s impact on “Yield at Issue” since 2008 for the Three Year and 10 Year Treasury Notes, and the 30 Year Treasury Bond.
With yields on cash and high quality bonds unlikely to keep pace with even low levels of inflation, investors are being encouraged to invest in higher yielding corporate bonds and global equities, all of which are well represented in the Wescott portfolio. Of our bond managers, Metropolitan West has the highest allocation to non-agency mortgage-backed securities, which should see prices increase as demand for these higher yielding securities goes up due to QE3.
For the near-term, the Fed’s measures should be a positive for the equities markets. For the longer term, however, the Fed’s actions could have unintended consequences. It is our hope that the Fed is able to make these programs short-term, in response to improving economic conditions.
The Risks of QE3
There are two very serious risks. First, the Fed has not demonstrated its ability to improve employment without causing runaway inflation. Second, the Fed is taking unprecedented risks on its balance sheet by buying long term debt at interest rates that it has manipulated lower.
We recently attended a presentation by Professor Gene Fama, of the University of Chicago; his work inspired the founding of Dimensional Fund Advisors (DFA). Fama believes that the Fed’s role should be to control inflation only. With the Fed selling short-term debt to buy long-term debt, in Fama’s perspective, the Fed has become the biggest hedge fund. What makes this particularly dangerous is that the Fed will need to unwind its balance sheet before interest rates rise. Otherwise, Fama predicts that the Fed will become insolvent if interest rates go up by 2%.
History provides a valuable context for the challenges we face today. President Johnson’s “Great Society” initiatives in the 1960s came at the cost of higher government spending and government deficits. See http://www.pbs.org/johngardner/chapters/4.html for additional perspective.
President Nixon, on the other hand, was determined to reduce government spending and control inflation. By 1970, inflation had peaked at 5% (up from approximately 1% in 1965). Nixon imposed wage and price controls in 1971 and tax cuts in 1972.
Political pressure on the Fed was intense under Presidents Nixon and Carter. In 1972, Fed Chairman Arthur Burns used monetary policy to fight unemployment and help President Nixon get re-elected. In 1976, President Carter won the election on his promise to balance the federal budget by the end of his first term (which he did not accomplish). On the day before Carter was inaugurated, it snowed in South Florida in the early morning hours – perhaps an omen of the havoc yet to come. The Carter years were difficult ones for the economy. In 1979, Carter appointed Paul Volcker, who aggressively increased interest rates to control inflation. In March 1980, President Carter prompted the Fed to impose credit controls; the Fed created the Credit Restraint Program to restrict lending. Consumers abruptly reduced their spending. This was an unexpected and negative result for the economy, and the program was wound down several months later. Volcker continued to serve under President Reagan and was the last Fed Chair to wrestle with inflation. None since have faced the challenges of double digit inflation, unemployment and interest rates. The Fed’s policies during the 1970s backfired. We experienced an extended period of upheaval as we debated the role of government and the size of federal deficits. We face similar debates today, and have been able to manage our current challenges with the benefit of low interest rates and low inflation. In the chart on the following page we provide a reminder of how difficult conditions became the last time that the Fed tried to achieve full employment. At that time, the target rate of unemployment was 4%.
Inflation finally came back down to the 5% range in September 1982; unemployment came down to the 8% range by January 1984. We remember the ravaging effects of inflation and see no virtue in being complacent. Actions we have taken since 2011 in our equity allocation via our exposure to global real estate, energy MLP’s and global natural resources should help protect the portfolio from inflationary trends that may follow this extended period of interest rate suppression.
It will be no easy task for current Fed chairman Ben Bernanke to keep control of inflation while targeting unemployment with QE3. Any increase in interest rates puts the Fed at risk, and makes it far more costly for the U.S. government to service its debt. Bernanke’s term expires in January 2014; his successor will need extraordinary skill to keep a fine balance between its policy objectives and the pressures of politics.
An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
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