Why Fed Won’t Derail Recovery

tdmoney15

OCEAN CITY – According to a number of financial commentators, the Federal
Reserve’s decision-makers will need to exercise split-second timing in the
coming months as they attempt to encourage growth and keep inflation at bay.

If the Fed tightens monetary policy too quickly by raising interest rates,
the argument goes, an economy that’s just getting back on its feet could
stumble again. But if the Fed waits too long to act, inflation could
spike — causing a new round of disruption in the equities market,
depressing stock prices and causing general financial chaos.

Ethan Harris, head of North America Economics at
BofA Merrill Lynch Global Research, questions this commonly held
view. Harris spent nine years at the Federal Reserve Bank of New York and is
the author of Ben Bernanke’s Fed: The Federal Reserve After Greenspan (Harvard
Business Press). He estimates that the Fed will have a solid three years to
shift to tighter policy before its actions — or
inaction — could trigger inflation. "That provides lots of time
to rebuild our economic foundation," Harris says.

"Inflation falls in the early stages of an economic recovery because
you have a lot of spare capacity," Harris explains. "Vacant
apartments, unemployed workers, underutilized factories — all those
signs of excess capacity signal companies to keep prices down."

That dampening of prices generally lasts two or three years into a business
cycle recovery, which should give the Fed more than enough time to keep rates
low and help markets heal without creating inflation. That sort of measured
response from our central bank is what investors are currently getting, and
it’s reasonable to think it will carry into the near future.

"The Fed has two modes: good cop and bad cop," Harris says.
"Right now we’re seeing a good-cop Fed trying to keep rates low and do
whatever it can to make sure we have a sustained recovery."

In contrast to the Fed’s deliberate behavior is the excitability of many
Fed watchers. This was underscored in February when the Fed raised the discount
rate — the rate it charges banks for emergency loans — by a
quarter of a percentage point, prompting a dip in the Dow Jones Industrial
Average. "I refer to those incidents as ‘Fed fakes,’ where the Fed makes a
minor technical policy change and markets react as if something important is
happening," says Harris. He points out that the discount rate is, at best,
a distant cousin of the federal funds rate. "Lowering the discount rate
was important at the height of the crisis, when many banks were borrowing
directly from the Fed, but raising it now simply means we’re no longer in an
acute phase of the crisis," he explains. "It has no bearing on the
federal funds rate, which is the rate that drives the cost of borrowing for
businesses and households." Is there too much cash in the marketplace?

Many of those concerned about the Fed’s near-term plans also contend that
it needs to tighten the money supply to offset the current excess liquidity in
the marketplace — the $1.4 trillion of bank reserves sitting on the
sidelines that some view as a potential inflationary time bomb. Harris
considers this another unfounded fear. He believes that with banks still
recuperating from bad loans and their customers suffering from weakened credit,
a sudden surge in lending is unlikely — making it unnecessary for the
Fed to take action.

Harris’s firm belief is that we will not see a hike in the federal funds
rate until early 2011 or a pickup in inflation until 2012 — which
suggests a policy that can likely continue to be favorable for the stock
market.

(A Merrill Lynch Wealth Management Advisor. She can be reached at
410-213-8520.)

 

Leave a Reply

Your email address will not be published. Required fields are marked *

*

HTML tags are not allowed.