The Federal Reserve has maintained its near-zero interest rate monetary policy since mid-December 2008, when it was adopted to thwart the financial crisis. In the October 2 Wall Street Journal, Charles Schwab wrote an op-ed titled, “Enough with the Low Interest Rates.” Mr. Schwab acknowledged that, when first implemented, the near-zero interest rate policy was an “emergency antibiotic appropriate for the illness.” However, he believes the policy has long outlived its usefulness and is now harming the economy by signaling the Fed’s lack of confidence. He also believes the policy is having no positive impact on consumer or business credit, job growth or spending. I agree.
Another pernicious effect of the zero interest rate policy is that it’s dramatically reduced the incomes of those who, as Schwab put it, have “played by the rules,” meaning (primarily) retirees who look to their savings to generate income to meet living expenses. I believe the real, but unstated, purpose of the Fed’s monetary policy is to continue to recapitalize banks, a purpose for which it’s been effective. However, the recapitalized banks aren’t increasing their lending to businesses or consumers. Instead, many are using depositors’ money, for which they now essentially have to pay nothing, to purchase U.S. Treasury bonds, making a risk-free return on the difference between the 3 percent the Treasury is paying them and the 0 percent they’re paying their depositors. The effect of the continuing near-zero interest rate policy is to tax savers to fund profligate federal spending.
The Fed’s monetary policy is aimed at, and primarily affects, short-term interest rates. At the same time, it maintains its near-zero interest rate policy—and because that policy is having little effect in juicing up the economy—the Fed is also engaged in something it calls “quantitative easing.” The terms used by economists often do little to illuminate their meaning. This curious phrase, recently much in the news, refers to the Fed purchasing longer-dated U.S. Treasury securities. A more informative term would be “printing money,” but that carries a very negative connotation.
Quantitative easing goes like this: The Treasury creates a security (a note or a bond); the Fed purchases the Treasury security with cash it prints; and the Treasury then uses the cash to pay for goods and services.
I understand economists agree that money created without productive effort is inherently inflationary. If so, what is quantitative easing but a prescription for future inflation? Don’t take my word for it: The commodity and currency markets are voting on Fed policy as you read this. The price of gold has climbed relentlessly all year, reaching record levels above $1,300 per ounce by the end of September and climbing toward $1,400. From the start of 2010 until early June, the euro plummeted from $1.50 to about $1.20 in value due to widespread concern about its viability in the face of the sovereign debt crisis in Greece. Since then, the exchange rate of the euro has reversed course and is now back near $1.40 despite little, if any, improvement in the fiscal situation in Europe. The dollar is suffering similar declines in value against most currencies in the developed world and is now at an all-time low against the Japanese yen.
What are the currency and commodity markets telling us? That overseas investors and business people aren’t fools: They see the dollar heading for long-term serious debasement from the Fed’s monetary and fiscal policy.
As the Great Depression took hold at the end of the 1920s and into the early 1930s, governments around the world, led by the United States, adopted trade protectionist policies based on a “beggar-thy-neighbor” mindset, which significantly worsened everyone’s problems. Chairman Bernanke, a noted student of the Great Depression, apparently aims not to make the same mistake. Instead, the Fed, with its persistent near-zero interest rate monetary policy and its quantitative easing, is attacking our economic malaise with a “beggar ourselves” mindset.
From an investor’s standpoint, near-zero interest rates and quantitative easing are a mixed blessing. By baking dollar devaluation (inflation) into the currency cake, the risk of rising interest rates over the mid- to long-term is heightened. This makes any longer-term fixed obligations, such as bonds and immediate annuities, a very risky proposition.
Conversely, domestic businesses with substantial operations outside the United States are likely to benefit, at least on paper, as they repatriate profits earned in currencies whose value is rising relative to our own. I believe this helps explain the continuing increase in U.S. corporate profits despite the anemic domestic economy as reported by the Bureau of Economic Analysis. Increasing profits, in turn, are a key driver of increasing stock prices and help explain the continuing strong performance of the stock market one the panic over Greek sovereign debt subsided in June.
So, until the Fed’s policies change, we will likely keep our client defensive holdings focused on short-term, foreign and inflation-adjusted debt. And we will remain fully invested in the equity markets, emphasizing international operations, regardless of whether firms are headquartered inside or outside the United States.
