Insights & Advice

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The Tipping Point

At the end of Wednesday’s Federal Open Market Committee Meeting (FOMC) the Fed announced they plan to buy as much as $300 billion of long-term U.S. Treasury Securities and over $700 billion in mortgage-back securities. In the short term this should mean lower mortgage and other rates for the consumer. The Fed is hoping this will reduce borrowing costs overall. Right now it seems to be working. A 30 –year, fixed rater mortgage is being offered for just under 5% and they could go even lower. The question we must ask is at what price?

If you follow the markets, you know that stocks rallied after the announcement and bond prices moved up even more. Some bonds had one-day percentage price moves not seen since the Eighties. Interest rates tumbled (bond prices move inversely to interest rates) across the spectrum from very short term treasury notes through to the 30 year “Long” bond. At the same time precious metals, energy and other commodities skyrocketed. The U.S. dollar plummeted. There is a simple explanation behind all these price movements—inflation.

Essentially, what the Federal Reserve is going to do is buy $300 billion of the trillions in debt that the government is accumulating in order to combat this credit crisis. Once they run out of that sum, they can buy more if they like. Sounds good so far but where is the Fed getting the money to buy this government debt? They are creating it out of thin air. That’s right, in times past the Fed would just turn on the printing presses and –Kazaam– more money, (today they do the same thing via electronic transfer).

Now imagine if you tried that. Your construction company prospers, so you borrow from the bank to expand and then recession hits. The business falters, cash flow dries up and you need to borrow more money to stay afloat. But the bank won’t lend you any more and you can’t find anyone else to loan you money.

“Fine,” you say, “I’ll just go down to the basement and print up all the money I need not only to expand my business but also pay off my bank debt.”

Now what’s wrong with this picture? Naturally, no one would take your bogus money since they don’t trust that it would be worth anything.

The difference between what you’re trying to do and what the Federal Reserve is attempting rests in how much we trust the government’s ability to keep the worth of the dollar where it is. By printing more and more money we are debasing our currency just as if we were printing it in our basements.

Clearly, investors are dumping the dollar because they are skeptical that this circular exercise of printing money to buy bonds to finance more and more spending leads to inflation. This is after all an old concept, one that governments throughout history have used when they get into economic trouble. Traditional inflation hedges such as gold, oil and other commodities are rising on the back of this announcement.

“Inflation,” scoffed one New York client I talked to today, “in a recession like this, we should be worried about deflation not inflation.”

In the short-term that is true. As jobs vaporize, economic growth plummets and consumers remain on a buying strike, there is not much reason for prices to go up. All these stimulus programs, bail-outs and interest rate cuts (short-term rates are essentially at zero) are designed to stave off deflation, jump-start the economy and get consumers spending again. But I suspect that all of the government spending and bail-outs plus the extra trillions that the Fed has thrown at the problem have not been enough.

“Quantitative Easing,” the name for this printing money, buying debt exercise, may be one of the few weapons left in the Fed’s arsenal. How much stimulus spending and pump priming will be enough to get the economy moving again without tipping us over into rampant inflation? No one, not even the Fed, knows where that tipping point is. On one hand, I applaud their efforts while with the other I fear they are simply applying a short-term fix that may have disastrous consequences down the road. In the meantime, maybe I’ll buy a little gold myself.

Posted in A Few Dollars More, Macroeconomics