The Fed has been back in the news this week for two reasons. First, controversial political figure Larry Summers withdrew his name from consideration as Fed Chair Ben Bernake’s replacement, when the latter’s term expires in January of 2014. Second, Bernake announced that the Fed would not taper off its bond-purchasing program as previously indicated, giving a jolt to markets. Both matters are significant to our still fragile economy. Here’s an easily-understood explanation as to why.
Summers, who served as Treasury Secretary under Clinton and was one of President Obama’s chief financial advisors when he took office amid the financial crisis, was a key architect of the financial market deregulation that occurred under President Clinton and helped create the environment that led to the collapse of the mortgage industry and the financial devastation that followed.
According to insiders, he was also one of the most influential of the President’s advisors and a driving force in the administration’s decision not to implement many of the serious reforms that others, such as former Fed Chair Paul Volcker, had argued were necessary to prevent a repeat of such a catastrophe in the future. While the President credits him with helping to stave off an even more serious crisis, many blame him for thwarting meaningful reform.
While Fed chairs have not historically been political footballs, the toxic partisanship in Washington coupled with Summers's polarizing nature meant that President Obama likely faced a protracted battle were he to attempt to appoint Summers. Sensing this, and likely not wanting to be drug through the mud over his colorful past, Summers gave the President an out. This created an opening for the Fed’s Vice Chair, Janet Yellen, a former Economist at U.C. Berkley.
In Yellen, the President would have the opportunity to appoint the first female Fed Chair. Given his dismal record on female appointments, this might be tempting, especially since Yellen comes with tremendous support in the financial community, where she is considered not only credible, but immensely qualified. In terms of policy, she’s also seen as more dovish, meaning less likely to implement the tough love fiscal policy that looms somewhere in the future.
That brings us to the second issue in this week’s news cycle. The Fed has been involved in a prolonged bout of quantitative easing, which is essentially a monetary tool in which central banks buy up financial assets from commercial ones, in order to expand the money supply and hopefully incite long-term lending. You’ve probably heard the term along with the monikers QE2 and QE3 – used to denote second and third rounds implemented when the initial program managed to stabilize, but not sufficiently stimulate the economy in the aftermath of the banking crisis.
Most recently, the Fed has been spending $85 billion a month in newly-printed money purchasing bonds from banks in order to incentivize them to loan out the cash and stimulate long-term borrowing (think mortgages). This is in addition to keeping the fed rate (what banks pay to borrow money) at nearly zero. As Bernake once put it, short of dropping money out of helicopters, the Fed is using pretty much every tool in its box to try to juice the economy.
This has also been good for Wall Street. When investors cannot get meaningful returns on traditional investment vehicles, they tend to chase yield through riskier assets, which is of course part of what led to the meltdown in the first place – low interest rates and high returns on mortgage-backed securities. Because such policies are not without long-term consequences, the Fed has been hoping to taper off its asset purchases, provided certain benchmarks were hit. And by taper off, they were only talking buying $65 million worth of bonds each month, rather than $85 million (the program was initially $40 million monthly).
However, Bernanke’s mere mention of turning the easy-money faucet even a little bit clockwise earlier this year rattled investors, who were again set to turn bearish in anticipation that he actually would this week. When he instead announced that the Fed would stay the course at least until its December meeting, markets hit record highs while the dollar fell.
The very fact that the Fed’s pronouncements have come to have such a profound impact on market dynamics is itself worrisome. Bernanke cited the fragile housing recovery –one of the few bright spots in the economy – and the rise in mortgage rates that the expectation that the Feds would taper their purchases brought on, as a primary reason to avoid the move at this time. He also noted that falling unemployment rates were probably more reflective of would-be workers dropping out of the search for jobs than real growth. Fear that higher yields back home would also pull too much money out of developing markets too quickly (which could also hurt the U.S. economy) was also thought to be a factor.
Perhaps more importantly, he also hinted that the GOP’s highly-telegraphed intent to again hold a gun to the economy’s head when it comes time to raise the debt ceiling had much to do with the decision as well. In reality, the Fed doesn’t have any more rabbits in its hat. Absent of Congress getting off of its collective rear and getting to work, rather than chronically jockeying to be the least worst when the 2016 race for the White House begins, it seems the U.S. economy is doomed to teeter along in hapless uncertainty.
Tinkering with the money supply and interest rates can goose the economy. But if it doesn’t trigger real growth and meaningful job creation, little is accomplished other than setting up the next asset bubble. This bubble would happen in markets rather than real estate as cheap money funneled into the only place seeing high returns leads to inflated stock prices. Mercantilism has its limits.
Washington needs to instead look toward infrastructure investments and other brick and mortar-based methods of stimulating economic growth via targeted spending that drills down further into the economy than the stock ownership class. Instead, the parties will most likely go to war over whether to make payments on spending they have already approved. You can probably guess how that is going to turn out.