Limits to the Power of Monetary Policy, Part 2

Not many of my posts generate a large number of quality responses.  Rather than respond in the comments area, I thought I would make this a separate post.  My views on the Fed are eclectic, and a little quirky, because I am a skeptic about the power of central banking generally, on both the upside and the downside.  I’ve done fairly well as a bond manager using my views of the Fed to add some value.  (I’m not a bond manager now, though I would like to run a bond fund again at some point.)

First let’s clear the decks.  I am not short.  I am not underinvested in stocks, or private equity.  I am also a “lone wolf.”  I don’t work for anyone.  When I worked for my prior employer, what I posted here and at RealMoney often disagreed with the view of the owner/founder (a genuinely good fellow, and a bright guy).  What I said, I said on two levels.  First, what should be: maintain a tight-ish monetary  policy, because the crisis is nothing the the Fed should be concerned about.  I care about public policy.  I don’t like inflation, which is very understated by the PCE, and understated by the CPI, for reasons that I have stated previously.  I also don’t agree with the concept of core inflation.  If you want to remove volatility, trim the mean, or use a median.  But excluding whole classes of goods is bogus, particularly when their removal lowers the CPI by a lot.

My view is that the temporary injections of liquidity will fail.  There will be enough demand for additional short term liquidity that the Fed will have to begin making permanent injections of liquidity into the system, and eventually cut the Fed funds rate.  Once you cross the intellectual barrier of providing enough incremental liquidity to keep the system afloat, you have committed to an uncertain course of action that will likely lead to rate cuts eventually.  If the goal of monetary policy shifts, so will the direction of policy, usually.

Has the Fed lost control of monetary policy?  Yes and no.  Yes, if they continue to do business the way they do now.  No, if they want to get ugly, and restrict the ways the banks do business, either through regulation or through a modification of the risk-based capital rules.  Even so, what can they do about stimulus via foreign purchases of US debts?  Not much, and even the US Treasury would have a hard time there.

Why have the markets been so good for 25 years? I have five reasons:

  • Demographics — the Baby Boomers entered their most productive years.
  • Easy Federal Reserve — after the overshoot of policy in the early 80s, the Fed was far more activist and willing (particularly under Greenspan) to throw liquidity at problems that should be liquidated by the free markets.
  • Capitalism — Almost every nation is Capitalist now, even if it is crony Capitalism.
  • Deregulation — business benefited from deregulation under Reagan (and no one else).
  • Free-ish Trade — Trade isn’t really free, but many nations are more willing to compete globally, and the deflationary effects of that competition have been a real benefit.

Finally, I am still thinking about what will benefit from a shift in Fed policy.  I mentioned high quality financials.  To me, that means companies like Hartford (or maybe PRU), which I don’t own at present.  Maybe Wells Fargo?  I’m not sure, but it would have to be institutions that have suffered a real price setback, where a permanent impairment of capital is unlikely.  But what other industries will benefit from lower financing rates?  That is the $64 billion question, and with that, I bid you good night.