FOMC Meeting

Posted by Jeff Carter
on March 16th, 2010

Today the FOMC meets. They are having lunch and smoking cigars while I type. Fed policy has been on hold since the financial crisis started. The only dramatic day has been the day they announced a quantitative ease last year.

The Federal Reserve, combined with fiscal policy have screwed up economic incentives in the marketplace. Banks are still severely damaged by the melt down, and are unable to expand their balance sheets and lend. While the credit market has unfrozen, money isn’t turning over. No velocity. So the Fed needs to alter its policy to spur activity.

Currently, if I am a prime bank, I can borrow from the Fed at basically zero interest, and re-invest in government treasuries at 3% or better. This is risk free profit, and doesn’t take a huge financial brain to realize. Plus, since bank balance sheets are so beaten up, it is a good use of capital by the bank.
Meanwhile, businesses can’t borrow from banks because the bank is either unwilling to take the risk, or they feel the opportunity cost of lending to a business is too high. So they buy treasuries and wait.

I think the Federal Reserve needs to change the stakes of the game. They need to raise short term rates by .25% today. This will increase the risk of holding treasuries. It might force a small amount of money to turn over into private businesses.

The risk of this sort of policy move can be seen in the Japanese crisis from the 1990′s. They lowered interest rates to zero as well. The problem was they feared inflation so much, that whenever there was a sniff of it, they raised their short term rates. This ended the recovery. It was a vicious circle. Last year, the US was in deflation. But now, there are signs that the economic environment is going to perk up a little. There is little danger of inflation at this point. We actually could use a little.

I think it’s important to recognize a couple of other constituencies. First, anyone with savings has been hurt by Fed policy. They have less to spend. It primarily affects retirees. If you planned your retirement based on a 4% rate of return, you are far away from that and in trouble. Second, America is a consumer nation. We import more than we export. A rise in rates will strengthen the dollar. This will help American’s dollars go further. They will feel less of a pinch. Commodities like oil, will fall in price since their trade is based on the value of a dollar. This will free up capital short term that can find it’s way into the economy. Recognizing this might entice the Fed to alter policy slightly.

There are those that say if the Fed raises interest rates it will decimate all gains made in the stock market. However, if the market can’t deal with a rate increase of .25%, then all the gains are built on a house of cards anyway.

UPDATE

Fed made no policy moves, no change in statement. However. they did say they were purchasing mortgage backed securities until the end of this month. They kept the door open for more purchases. Essentially, the Fed is transferring crappy credit onto it’s books. What will it do with that junk? Speculation is that they might transfer it to Fannie and Freddie. Then declare the quantitative ease is still on. At that point, you have to fear inflation, and buy gold.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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