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Fed Puts the Pedal to the Metal

Fed Puts the Pedal to the Metal

Yesterday, the Federal Reserve went pedal to the metal on monetary policy by announcing an open-ended bond buying plan. The past few weeks’ rally in asset prices was vindicated by the announcement. Last minute doubters who believed that the FOMC would remain on hold were proven wrong. With the doubters on the sidelines, equities and resources have responded with strong upside moves. The important lesson to learn is that the real economy is playing less of a role in asset price performance as monetary policy offsets deleveraging forces.

The details of the plan were bold; the Fed has committed to buy $40 billion in mortgage-backed securities (MBS) each month until conditions in the labor market improve  and will hold interest rates near zero through mid-2015. Additionally, the Fed will continue its Operation Twist program through the end of this year, in which it is selling its short-dated Treasuries and buying longer-dated Treasuries. The net impact of this buying will be to increase the long-term holdings of the Fed by $85 billion each month through 2012. The Fed also suggested it would “undertake additional asset purchases” until labor conditions improve and said that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” Essentially, the plan amounts to an open-ended asset purchase program and zero interest rate program. This is what we at Euro Pacific have long anticipated the end game would be.

What are the implications of such a plan for investors? We think it should become increasingly obvious that a large component of asset price performance is being driven by monetary policy – not economic recovery. We all know the economy has seen difficulties this year, as even the Fed recently reduced its growth forecast. Since the beginning of the third quarter, the S&P 500 has risen 7.71% while analysts have reduced their estimates for the index’s third quarter earnings by 4.6% (Bloomberg, 2012). As the private sector deleverages through defaults on mortgages, paying down debt, job loss, and higher lending standards, the Federal government is offsetting this trend by running a large deficit and using monetary policy to dampen its effect on the Treasury market. The chart below displays this effect clearly by showing year-on-year credit growth on a quarterly basis for consumers and the federal government.

Total Credit Market Growth in Households and Federal Government, 2006-2012

Total Credit Market Growth in Households and Federal Gov, 2006_2012
Source: Federal Reserve Flow of Funds Data, 2012
 
But while easy money and large fiscal deficits might be offsetting the force of deleveraging pressures in the household sector for now, the cost will be an upsurge in prices as inflation takes hold. What can we expect in terms of monetary policy from the Fed when this happens? As we’ve said in the past, it’s likely that the goal will be to keep inflation abnormally high for some time in order to reduce the debt burden that the Federal government has built up. In our opinion, these conditions stand to benefit investors in foreign stocks, currencies, and commodities.

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