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Inflation, Empathy, and the Fed

I write this as the Fed is in the midst of their final two-day meeting under Chairman Bernanke, and to tell the truth I am feeling a bit wistful.  While, as a big fan of freedom and honesty I cannot say that I ever felt comfortable with the Chairman’s heavy interventionist hand, I am sympathetic to the immense challenges he has faced during his tenure.  In 2008 it really did seem like the world economy was about to collapse from a banking and finance crisis the like of which no one had every quite seen.  And, with global governments including our own flailing for any answers or solutions, it is understandable that the Fed felt compelled to do whatever it could by introducing massive systemic liquidity to calm the storm.

Now, five years hence, the world of finance and investments has become more heavily influenced by the Fed than ever and one must read tealeaves in order to assess what lies ahead. I find myself in rather frequent discussions these days with friends attempting to read these tealeaves, and most always the conversation finds its way to us pretending that we run the Fed, and then asking ourselves what it is that we would do now.

Facts: The global economy remains fragile and this fragility is being reinforced by a seemingly high degree of economic uncertainty that is impacting everyone’s decisions about spending, borrowing, investing, hiring, and growing.
Employment in the U.S. has shown some better headline numbers, but a deeper analysis reflects a much graver situation as part-time and lower-income jobs make up too much of the new jobs being created, while the levels of labor force participation continue to hover around all-time lows and the long-term unemployed statistics remain frustratingly high. Europe remains a structural mess, and one cannot help but believe that a rather large shoe may yet fall there. Banking regulators have done their best to clamp down on banks’ risk-taking, with the recent passage in the U.S. of the Volcker Rule being the latest and possibly the most important step yet the largest six banks in the U.S. have gotten significantly larger since ’08 and the concentration of banking assets into those six much greater. Where banking goes from here, and how it will serve the global financial market seem to be questions that few have even asked (blog on this to follow in the near future). Suffice to say that Ms. Yellen will have her hands full.

As the Fed contemplates whether to dial back on its QE policies, it has become apparent that inflation targeting has replaced unemployment as the heart of the debate, which may be perplexing to some of you. Initially you may recall that Chairman Bernanke said he’d end QE when unemployment levels reached 7%. Now that we are there the discussions have moved to the Fed’s concern that inflation is too low.  As a man who remembers well the travails of high inflation during the Carter administration, and the kudos bestowed upon a former Fed Chairman named Volcker for beating inflation, it seems a bit odd to me to hear that we now wish inflation was higher. What gives?  Isn’t it better for things to cost less?  Doesn’t that make our savings more valuable and our purchasing power greater?  The answer to this quandary lies in the sad fact that we in the past few decades we have become a debtor society as opposed to a saver society.  We have a massive net debtor position, owing far too much, and in such a circumstance inflation may be our only way out.  The excessive debts built up in order to jury-rig (what now appears to have been fictitious) growth these past decades now seem to mandate that we inflate that debt away.  In such a scenario, savers will be punished, but in a debtor dominated society their interests are in the minority and must therefore yield to the interest of the majority.  Not fair, you might say?  Perhaps, but this is democracy at work.

So, if I was the Fed Chairman, I think I would probably continue to pursue a very easy monetary policy, manipulating interest rates to be super low and utilizing all of my tools to do so including continuing QE.  A Fed balance sheet of $4 trillion would have been considered beyond the pale until rather recently, yet here we are and most people don’t seem to object.  To go from $4 trillion to $5 trillion, as we will almost certainly in 2014, and then maybe someday all the way to $14 trillion seems much easier now.  Surely, the other global central banks (Japan, China, Brazil especially) will be continue to be forced to follow our lead, lest our money printing cause our dollar to decline against their currencies and thus destroy their export-dependent economies.  The ECB will try to keep up, but the conflicting interests of its constituency may cause some real problems in Europe.

So, as we approach the end of the year, (and I say this with great temerity) I would say that the situation that led to QE has not really changed too much and thus there seems to be no reason to believe that the period of easy money will end anytime soon.  And, the by now rather predictable effects that will have on the investment and financial markets will likely continue apace, perhaps making today’s price levels and rates of return look downright attractive in hindsight. With QE going on, cash has not been a great asset to hold, however tempting it has been to do so in this period of great uncertainty.  This may continue to be the case.

I wish the best to you all in the coming 2014. We continue to live in very interesting times.

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