Monetary Bazooka Fired

The Federal Reserve Open Market Committee (FOMC) today announced a new program of quantitative easing that goes above and beyond all previous actions they’ve taken to stimulate the economy. For the past several years, the Fed has been buying primarily long-term treasuries with essentially newly printed money, in an attempt to inject liquidity into the economy and keep long-term treasury rates (the rates that long-term loans like mortgages rely on) low. The new program announced today, which goes into effect starting tomorrow, has the Fed buying mortgage-backed securities in the amount of ~$40 billion per month with no fixed end date. The purchase of these securities should directly lower mortgage rates (all else being equal) and allow for another wave of refinances for those who qualify. The purchases themselves were mostly expected by the market given lackluster economic growth and an anemic job market. But, the open-ended nature of the purchase program is the bazooka of monetary weapons.

Ben Bernanke, chairman of the Fed, indicated that the Fed will continue the monthly purchases until economic conditions improve. Read another way, that means the Federal Reserve will continue print money until there is enough money to go around. That money will flow into the economy through lower mortgage and other loan payments for borrowers and through the reduced incentive to hold cash savings since interest rates are virtually zero. If $40 billion per month isn’t enough, they’ll do more. If mortgage-purchases aren’t enough, they’ll print money to purchase other assets too. It’s a commitment that essentially puts a floor under the economy and under asset prices, thereby removing the risk of deflation. Without the risk of deflation (think of housing prices falling), the desire to purchase assets can return (think of people in their early 20’s deciding to buy condos again instead of renting). While the ramifications of the commitment will take a while to filter through the economy, they should result in the following:

· Lower mortgage rates for those with good credit attempting to obtain conforming loans (loans for principal residence that are under the FHA loan limits for the county of residence – typically $417k)

· Another wave of refinancing reducing payments for existing borrowers and freeing up more for discretionary spending

· Reduced risk in house price declines leading to more buyer confidence leading to a bottom to the housing market

· Higher business confidence that the economy will not “double dip” back into recession (the Fed simply won’t let it happen)

· A very gradual improvement in the job market

· A continuing erosion in the value of cash (no interest paid and the cost of living will start to increase more rapidly, especially in volatile food and energy prices)

· Higher inflation (virtually a guaranteed byproduct in eliminating the risk of deflation), higher energy prices, higher food prices.

It’s that higher inflation that will be the next big economic problem in my opinion. How fast it happens is unknown, but when it does, the Fed will have to reverse course and start extracting stimulus or face a 1980s-like bout of hyperinflation. Their forecasts are for that to occur beyond 2015 (they currently promise to keep rates low through 2015 and wouldn’t do that if they didn’t think inflation would be in control through at least that year). I’m not so sure, since I think a promise for an unlimited amount of stimulus could very quickly cause inflation expectations to become unanchored. Either way, taking deflation, double-dip recession, and maybe even depression off the table is certain to be a short-term net positive on the economy in aggregate. It’s also virtually certain to make cash have less and less value over time. So, what should you do to take advantage of today’s changes:

1) Only hold enough cash to serve as an emergency fund and to pay for short-term upcoming lump-sum purchases.

2) Avoid long-term fixed-income commitments (long-term bonds, long-term cd’s, fixed annuities without an inflation rider).

3) If you own a house, look into refinancing or re-re-re-refinancing your mortgage.

4) If you’re renting, you live in an area where house prices are reasonable in relation to rent, and you have enough money for a 20% down-payment, consider buying a house. I’ve been very patient in delivering this message but my confidence is now fairly high that affordability (based on the mortgage payment you’d expect given home price and interest rate) will peak by Spring ’13.

Most of all, stay alert and stay flexible. Today’s announcement is unprecedented and therefore at least partially unpredictable. Bazookas are powerful, but they’re not the most precise weapon and they may have some collateral damage. If we’re using imprecise, extremely powerful, and somewhat unpredictable tools to try to control the economy, the result, well, let’s just say this is probably not the final chapter of this economic cycle.

Advertisements

2 thoughts on “Monetary Bazooka Fired

  1. Pingback: Market Update 6/20/13 | PWA Financial Tastings Blog

  2. Pingback: Market Update – End of Q2 2014 | PWA Financial Tastings Blog

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s