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What the FED is Doing is Irrelevant and Here’s Why!

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In talking to many clients, I realize there may be a false notion going around that suggests the FED is not doing a great job executing fiscal and monetary policy.  Actually, economic theory suggests that our government (separate from the FED) is responsible for determining fiscal policy (e.g. taxes, trade, etc.) while the FED is to carry out monetary policy. However, these two roles have been co-mingled over time, so it seems worth evaluating the question of whether the FED is doing a good job or not.  In the 1940s, an economist named Abba Lerner explored the doctrine of functional finance. It basically states that:

The first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce.

 


In that context (which I deem as very sound), let’s tackle some simple questions…

Q.  What is the goal of monetary and fiscal policy?  

A.  To keep aggregate demand (e.g. total spending in the economy) at the level of aggregate supply (e.g. total amount of goods and services in the economy).

Q.  What is the result of any imbalance?  

A.  Basic economics states that two conditions exist when there is no equilibrium.

Condition #1 – If aggregate supply exceeds aggregate demand this will result in unemployment since the level of goods and services being offered has not enough demand to consume them all.  Thus, the providers of those goods and services will then be forced to lower prices which will cut profits and cause less business expansion thereby reducing the need for labor (e.g. a decrease in the rate of employment).

Condition #2 -If aggregate demand exceeds aggregate supply this will result in inflation since the level of goods and services being offered is not enough for all that would like to consume them.  Thus the providers of those goods and services will tend to raise prices causing the consumer’s purchasing power to be eroded.

Although inflation is always a much easier problem to handle (vs. unemployment) the government only has two ways to control it:  raising taxes (e.g. adjusting fiscal policy) which reduces the amount of income left available for consumption or raising of interest rates (e.g. adjusting monetary policy and carried out by the FED) which makes consumers less inclined to borrow to bring future consumption forward into present-day consumption.

Q.  How does the government get into the picture?

A.  When the FED is ineffective in employing its tools to regulate the economic cycle, economic theory would suggest the government gets involved as a last-ditch effort to “save” an economy from recession or depression.

One example would have been the Great Recession (2007-2009) where the government raised the (overall) level of consumption by purchasing government bonds (aka “printing money”).

How did this help?

When the government bought bonds the proceeds from the transactions where passed to the holders (e.g. banks, financial institutions) through “quantitative easing”, thereby giving these institutions the wherewithal to increase their lending facilities.  The more money a bank has on deposit the more it can lend to prospective borrowers.  This compelled consumers to pull future consumption forward by borrowing more at much lower interest rates.

However, this has its consequences as inevitably interest rates can not remain artificially low for an extended period of time unless too much borrowing occur or the effect of quantitative easing becomes moot.

Q.  What is the effect of too much borrowing by the government?

A.  Not much, especially if you subscribe to Lerner’s doctrine.

Ultimately, the government’s control of how much currency is in circulation nullifies the rate at which it repays its debts.  The more important focus is the government’s use of borrowed money.  It is usually to increase aggregate demand or increase the level of spending.

The question is always then how effective is this employment of borrowed funds, not how much have they borrowed.

Q.  What is the effect of too much borrowing by non-government entities?

A.  Since low-interest rate policies (“LIRPs”) don’t place restrictions on who can and cannot borrow, one popular outcome is the carry trade.

One example of this has been seen in the last several years, in which USD was borrowed at low-interest rates to buy foreign securities and currencies that paid higher rates of interest.  The difference between the cost of borrowing and the interest paid was called the “carry”.

Many analysts believe this phenomenon artificially pushed up the value of securities in the global financial markets causing market valuations to trade well beyond their actual worth.

On the other hand, there is also evidence pointing to borrowed cash being “sidelined”.  In other words, cash is not invested and just hoarded inevitably waiting for the next financial collapse.

The latter theory is less popular, in that, in the short run this is a relatively costly trade because there is no return being earned on sidelined cash.

Q.  What is the “so-what” of all this?

A.  Ahhhh. A much easier question to answer with a definite answer.

Regardless, of all the economic theory that can be supposed, we are living in very unconventional times.  There is a constant battle between the desire for return and prudent risk to be taken in your investment strategy.

An investor should consider setting realistic goals in a systematic way with the assistance of a financial professional.

You should construct an investment plan to withstand the test of time, regardless if you think the FED is doing a good job or government spending is out of control.  Inevitably, your resolve to weather the ups and downs of several economic cycles will contribute to your success.

Time after time, I’ve seen the most successful investors create a sound plan and remain with that plan to achieve their financial goals.

In that context, it really doesn’t matter what the FED does as much as what YOU do.

Invest wisely!

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As an advocate for financial education, I love to share my knowledge in a “jargon-free” way to help you understand what it will take to win with your money!

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