12/13/12 - Santa Is Real After All—Up to a Point

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 13, 2012 11:28:52 AM

and tagged Fiscal Cliff, Politics and the Economy

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So the big story today is that the Federal Reserve is now explicitly linking its interest rates to U.S. unemployment. It’s kind of the reverse of the Santa revelation. Remember when you found out that Santa wasn’t real? How you kind of knew it but weren’t happy to have it confirmed? Now we kind of knew that the Fed was keying on unemployment, but again we’re not all that happy to have it confirmed.

The story made the front pages of the Financial Times, the Wall Street Journal, and the New York Times, in all cases above the fold. So in the eyes of the mainstream—and especially the financial—media, this is a big deal. I agree, for a change. The Fed has explicitly moved toward supporting the real economy, in employment, and away from supporting the financial economy, with inflation. Clearly, it is worried more about the former than the latter.

The Fed has a dual mandate: price stability and employment. In normal times, price stability gets most of the attention, but over the past several years the Fed has clearly abandoned any anti-inflation worries. In fact, it has tried to create inflation in order to fend off the threat of deflation.

Creating inflation sounds like the worst sort of heresy for a central bank, but in fact deflation can be worse. Inflation benefits borrowers—whose debt remains constant—even as the dollars used to pay it back become cheaper. In strict moderation, inflation can be seen as a positive factor. We also understand how to fix inflation problems.

Deflation, on the other hand, benefits creditors, as the debt balance remains the same but must be paid back in dollars that are worth more, making it harder. In an over-indebted economy like ours, deflation would make any recovery that much more difficult. We also do not understand how to fix a deflation problem—something with which Japan has struggled for decades.

So the Fed is definitely aiming to create inflation rather than deflation—and is well aware that it might have to clean up the mess later—to avoid something worse. Fortunately, this coincides with the other half of its dual mandate, which is to maintain employment levels.

In order to suppress interest rate levels, the Fed will continue its quantitative easing operations, injecting money into the economy through purchases of Treasury and mortgage bonds with the intention of keeping borrowing cheap and forcing investors to invest in riskier assets to generate income. It is doing this because it is scared of continued weakness and especially of the fiscal cliff. Bernanke, who coined the term, has explicitly stated that the Fed cannot make up for the effects of the fiscal cliff, should Congress not act.

We are now approaching the end of the Fed’s abilities. It is buying a large proportion of the bonds available in the market, so it has very little room to expand that effort. It has extended the support indefinitely, so it has no room to go further. And, although I am sure that there are further contingency plans, the Fed is getting further and further away from what has historically been a central bank’s role. At some point, it will hit a limit. At the end of the day, even Santa may have to say, “Enough.”

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