August 26, 2011

The Fed’s Empty Toolbox: Analysis

And why there are better options than safes and mattresses for your wealth

A NYSE trader watches a monitor after end of Ben Bernanke's speech on Friday. (Photo:AP) A NYSE trader watches a monitor after end of Ben Bernanke's speech on Friday. (Photo:AP)

Initial reports of Friday’s stock market surge suggest that market participants were reassured by Fed Chairman Ben Bernanke’s vague pledge to consider the "range of tools that could be used to provide additional monetary stimulus." I disagree with that assessment, but more on that below.

First, let’s take a closer look at Bernanke’s toolbox. I see only two tools. The first is interest rates. By keeping rates at effectively zero, I think it’s fair to say the Fed chairman has already used that tool; he simply can’t accomplish much with any further tweaks to rates.

The second tool I see is the Fed’s balance sheet. Whether Bernanke prints money, makes large-scale asset purchases or extends credits to banks, it all ultimately is an expansion of its balance sheet. Before the recession the Fed’s balance sheet stood at around $700 billion to $800 billion; after the Fed’s bond-buying program (QE1), assets at ballooned to about $1.7 trillion. Because the economic recovery was so fragile, Bernanke announced QE2 last November, adding another $600 billion to its now over—$2 trillion balance sheet.

Many commentators believe our current weakness shows the failure of quantitative easing, while others argue that catastrophe would have resulted had Bernanke not relaxed monetary policy. I am not arguing either viewpoint here. I am only suggesting that the effectiveness of any further easing must be in serious doubt; we simply lack the financial credibility to so.

The best measure of our credibility is the dollar, which used to buy 1.25 Swiss francs in 2007 but is now worth just 0.81 Swiss francs. The dollar might still be green and have George Washington’s picture on it, but—psychologically—further easing will make it feel more like an Argentine peso.

In short, I don’t think the Fed really has tools anymore; it’s left with just diplomacy—a polite way of saying that it can only bluff. But as any poker player knows, the ability to bluff is also a perishable asset if used too often.

When the Fed announced earlier this month, in the face of persistent economic weakness, that it would keep its benchmark rate at near zero till mid-2013, it was an admission that a) it can’t use its rate tool and b) it can no longer expand its balance sheet in any meaningful way; it therefore conferred an aggressive calendrical blessing on U.S. investors.

But when the next scare occurs between now and 2013, will Bernanke unleash “Calendrical Easing II”—offering to keep rates at near zero till 2015? Whatever clever policies are pulled out of the “range of tools” at the Fed’s disposal will have less and less impact and credibility.

I believe it is highly likely we will have a crisis quite a bit sooner than mid-2013, and it will likely emanate from the insolvency of large financial institutions. Trying to figure out how to defend oneself, or even profit, from such an eventuality, I thought I’d look at the example of Greece, currently in the vanguard of economic crisis.

Greeks have been taking their money out of banks, paying down debts, stuffing their mattresses or renting safe-deposit boxes. I do not recommend the latter two of these options, though they’re better than the unfortunate experience of one poor retiree from Crete who, The Wall Street Journal reports, hid his money behind the brick wall of his home only to find a few months later that rats had eaten through a life savings of euros.

I tried to find the stocks of companies that make safes, but public companies like Diebold do not appeal to me because their biggest customers are … banks! The companies that I found that make home-use safes rather than bank vaults are privately held. In any event, while shares in a large commercial manufacturer of safes would definitely seem like an appealing investment, I believe the doomsday portfolio of guns, cans of beans and cash is really the wrong approach.

And that brings me back to the real reason I think the Dow closed up 134 points on Friday. Despite a lack of reassurance from Bernanke, an impeding banking crisis and a weak economy, corporate profits are at an all-time high, according to data released Friday by the Bureau of Economic Analysis.

This demonstrates anew that corporations are very skilled at finding ways to preserve profits even in tough times. Granted, profits will suffer if we revert to recession. And while today’s malaise may not be sufficient to bring one about, a full-scale banking crisis could surely do it, eventually.

But too many worrywarts have lost wealth and squandered opportunity by being “right” about the coming economic crisis too early. So, forget about the safe or the mattress. If you have debt, pay it off; if you’re able to refinance at today’s deal-of-the-century low rates, do that. But if you’ve got any capital to deploy, there is no substitute for buying (whether equities or real estate) wisely, holding for at least five to seven years and closing your eyes.

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