Tuesday, September 21, 2010

Federal Reserve Behind the Curve?

A wise investor always keeps in mind the spectrum of risk. For any given investment there is a spectrum of likelihoods, including unforeseeable events that could bring an upside or downside. With bonds, of course, you have a lot less complexity than with stocks, and with Federal bonds you have less complexity than with corporate bonds. Typically, however, while bonds limit some downside risks, they also limit the upside.

The economy (whether defined as the United States or as global) has an astonishing number of variables at play at any given moment. The decision makers at the Federal Reserve have considerable experience in the banking sector, but typically have little experience in manufacturing or, for instance, in the black market economy (which is mainly services performed by individuals who do not report their income to the government). Their collective record for steering the economy in the past two decades is dreadful; if they were drivers, they would have had their licenses taken away.

The history of the United States, and other nations, is replete with instances of false booms based on excessive credit and speculation. Real economic growth does require a degree of credit, but it is mainly based on savings and profits that are then redirected to new growth opportunities. Americans are now saving, which is good. They should save considerably more, but in aggregate won't be able to until employment returns to "normal" levels. Judging from price-to-earnings (P/E) ratios, American businesses are generating profits and mostly don't need much in the way of credit to keep up a modest pace of expansion.

Today's Federal Reserve statement (September 21, 2010) gives the impression that the economy is still growing, but at a slower pace than earlier in the year. Of course. Aside from the inventory restocking bounce that always follows a recession, we had a lot of reluctance to anticipate growing demand because of the "double dip" howling of the wolfpack. But there was no double dip, not even during the Euro freeze.

Growth is growth, and it will speed up and slow down from month to month and sector to sector. What the Federal Reserve won't admit is that its zero-interest rate policy is not doing much more for the economy than, say, a 2% interest rate policy would do. It is helping the banks (recall that the Fed does not represent the people, but is all too much like a bank collusion mechanism), but they aren't lending much. When they do lend, it is often on credit cards at ridiculously high interest rates. Which at least encourage consumers to save rather than spend.

The fed could easily start raising interest rates now, showing some confidence, and normalising the situation. At 0.25% today, maybe 0.5% after the holidays, working towards whatever is appropriate by the end of 2011, probably at least 2%. If the recovery is slower than I expect, rates should still go up gradually to at least 1.5%, which is very, very accomodative.

The Federal Reserve can't make a recovery. That will be built by the people themselves, as it always has been. There is a lot of work that needs doing, notably repairing millions of homes that have been damaged by thieves and neglect during the past 3 years. Schools are overcrowded due to teacher layoffs. American services and manufacturing are becoming more competitive with China because of rapidly increasing wages in China. This does require capital as well as person-power; the banks could play a part.

We know what the banks will do. When it stops raining, they will start handing out their supply of umbrellas.

Today's Federal Reserve decision to leave interest rates near 0% may be politically popular, and popular with Wall Street banks, but it is not a responsible decision given the data available.

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