For the last two decades the Fed has been very aggressive in their attempts to short circuit the ability of the economy to fall into recession. Granted, issues like the Long Term Capital t down in '98, Y2k scare (that seems like that was another lifetime ago), 9/11, and the sub-prime mortgage/derivative debacle all appeared to create a true sense of urgency. The common thread in the Fed’s reaction has been to lower interest rates and make money more available within the financial system. The intent is to inspire borrowing, leading to GDP growth and hence more jobs.
The problem is that the strategy had unintended consequences in the formation of stock, real estate, and derivative bubbles. These bubbles have unfolded in such close proximity to each other that a constructive rebuilding process has had no time to unfold. Currently the Fed is stuck with a similar dilemma. The initial recovery strategy of lowering interest rates (they now cannot go any lower?), increasing liquidity, and government stimulus has failed to lift the economy effectively. Last week they announced another round of quantitative easing (QE2) where they will purchase $600 billion of Treasury securities and another $250-300 billion in reinvestment interest through the 2nd quarter of 2011. This is intended to lift asset prices (stocks, bonds, and commodities), which hopefully will create confidence, and again hopefully in the meantime the economy will gain significant traction. Another intended outcome is a lower US dollar which will help our multi-national corporations with their exports. Sounds good on paper, but as the Chargers have found out, the real world is often a different story.
“I know what you're thinking. 'Did he fire six shots, or only five?' Well, to tell you the truth, in all this excitement I kind of lost track myself.”
It is apparent that the Fed is running out of bullets or has run out of bullets. Another newsletter writer reminded us of the Dirty Harry movie where Clint Eastwood growls his famous line "I know what you're thinking. 'Did he fire six shots, or only five?' Well, to tell you the truth, in all this excitement I kind of lost track myself... You've gotta ask yourself one question. Do I feel lucky? Well, do ya punk?" Obviously the Fed is hoping this QE2 silver bullet is going to bring their luck around. If the strategy does not work and the economy can’t support these inflated asset prices the potential for another burst bubble is apparent.
We believe recessions are a natural part of the business cycle where the less efficient companies fall to the wayside, previously overpriced assets become affordable, and inflation is kept in check. It seems to us that the last few recessions were rushed to the finish and never fully flushed out some of the excesses that occurred during the boom. Granted they can point to the events we mentioned at the beginning of this piece for reasons to take swift action, but we believe one of the reasons we are at this juncture is due to the absence of a deep cleansing process similar to the recession in 1981-82. Then Fed head Paul Volcker raised interest rates into the teens to kill inflation and reset the economy. We remember mortgage rates reaching 18% and CD’s paying 15%. Those high rates heading lower were a key component of the Secular Bull Market that began in that period. That wind is not currently at the Fed’s back.
It sure appears to us that the election cycle plays a role in the process. Since Bush 1 every new President has inherited a struggling economy. The thought of having a cleansing period of low economic growth on their watch is unacceptable. The first job of a new President is to get re-elected. Recessions, no matter how beneficial in the long run, do not garner votes. The elongating of campaigns is no help to the cause either. Four years is not enough time to implement strategies that have effective gestation periods of a decade. Corporate America has a similar issue as the results of the next quarterly report are considered long term planning.
Essentially we believe our instant gratification demands as a nation has landed us in the deepest economic swamp in eighty years. The issues of Medicare and Social Security are no longer issues that are off in the future, the strategies that will solve those potential insolvencies have to be created soon. Our leaders are going to have to have vision that sees past the next election cycle and the political will to tell the truth. We as voters are going to have to become more issue oriented versus party and personality driven. We were hoping a couple of years ago that this financial crisis would be the wake up to shift these priorities. Hopefully there are enough of us who hear the alarm clock to create a sea change.
Whoops? We were writing about the Fed’s current quantitative easing strategy and ended up on a soap box. So far the markets have responded to the announcement of the Fed’s intention moving higher without pause. My take is the stock market has an eerily similar look to the instant gratification conversation above. A more steady eddy climb with consolidations which include back and filling tends to create a more solid foundation than an uninterrupted sprint. The lagging economic numbers like last Friday’s employment report are obviously not factors when the fire hose of liquidity is on.
The end result could be a well timed bridge to the period where the economy gains significant traction or a perilous game of musical chairs. At this point we hear the music is blaring and the tune playing is “Don’t Fight the Fed!.” Just make sure you have a chair (exit strategy) if the music stops prematurely. Maybe the music will never stop as the Fed makes the QE process into a Rocky remake with QE3 already in the planning stage. Easy money is a tough habit to break.
Did You Know
Taxing Data - Based upon 2008 tax data, it took an adjusted gross income of $380,000 to rank in the top 1% of US taxpayers, a group that paid 38% of all federal income tax for the year. In 1980, the top 1% of taxpayers paid 19% of all federal income tax. Again based upon 2008 tax data, it took an adjusted gross income of $160,000 to rank in the top 5% of US taxpayers, a group that paid 59% of all federal income tax for the year. In 1980, the top 5% of taxpayers paid 37% of all federal income tax. Americans filed 140 million tax returns for calendar year 2008 income. Through the use of deductions, exemptions and credits, 52 million tax returns of the 140 million total returns (or 37% of all returns filed) paid zero federal income tax (source: Internal Revenue Service).
Final Thought
“Always and never are two words you should always remember never to use”- Wendell Johnson
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