Getting Off the Treadmill

The Dow experienced a triple-digit sell-off yesterday, which has been somewhat of a rare occurrence over the past few months. In my estimation, the sell-off was triggered not only by the delay in the Greek deal (which certainly was a factor), but also commentary coming out of the Fed. The Fed released the minutes of its latest meeting, which suggested to me (and others) that another round of asset purchases (QE3) is not an imminent possibility. In addition, Dallas Fed President Richard Fisher blatantly told reporters yesterday that "there will be no QE3." And finally, Philadelphia Fed President Charlie Plosser was on the tape Tuesday with his standard, albeit more aggressive, hawkish comments. These developments came as somewhat a surprise following Bernanke's ever-so-subtle foreshadowing of a QE3 following the most recent Fed meeting. Bernanke has since repeated that the Fed stands ready to do more if necessary. Unfortunately, the markets have become conditioned to read into a statement like this. The interpretation is that there WILL be more action by the Fed. At the same time, markets have essentially priced in an extension of the payroll tax cut and an eventual extension of at least a portion of the Bush tax cuts. Therefore, we cannot help but conclude that the markets continue to be driven by the promise of easy monetary and fiscal policy rather than sound underlying fundamentals.

I was in Newark, Dela., on Monday and Tuesday, and I had the opportunity to sit down with Philadelphia Fed President Charlie Plosser. Plosser is a well-known hawk within the Fed system, meaning that he believes the central bank should be more vigilant in ensuring that inflation does not become a big problem in the future. He said that the Fed's independence from politics is essential because the central bank needs to make decisions that ensure the LONG-TERM health of the economy. The first implication, of course, is that politicians are only concerned with near-term economic conditions as they must run for re-election every so often. In other words, no politician wants to make a decision that might result in near-term pain among his constituents because that would result in the loss of votes. Nothing novel about this idea. The second implication, however, is that the Fed's monetary easing has indeed increased the risk of widespread inflation in the future. This inflation could show up in the form of higher commodity prices, higher prices for finished goods and services, and/or asset bubbles (read: stocks and housing).

Plosser believes that the economy and financial system are no longer in a state of crisis, and therefore monetary policy should not continue at crisis levels. In particular, adding a "commitment" to keep the Fed Funds rate at 0 percent through 2014 is a senseless pledge as future monetary policy will be determined by economic conditions and not by the calendar. We voiced this exact sentiment in our Jan. 25 Market Commentary (and we repeated it the following week). Therefore, what was perceived by the markets as incremental easing was in fact simply a worthless pledge.

It should be noted that Plosser is not a voting member on the FOMC at this time. In fact, Richmond Fed President Jeffrey Lacker may be the only staunch hawk on the Board at this time. What does this mean? It likely means that investors will eventually get what they want yet again. Sometime down the road, while it may not be at the next couple of meetings, the Fed will likely implement QE3. But it has to end somewhere.

So what are we to make of the divergent opinions within the Fed? It our view, there are two possibilities. Either 1) Chairman Bernanke has a legitimate disagreement with Fisher, Lacker and Plosser; or 2) Bernanke does not expect to ever do a QE3, but he wants investors to believe in that possibility (or indeed likelihood) so they become emboldened and bid up the prices of risky assets. If the latter is the case, I would speculate that Bernanke is trying to buy time for Congress to provide more clarity on issues such as tax policy and regulation. Our fear is that if the latter is true, we could all be in a lot of trouble!

I've never been a fan of parsing each and every utterance from Fed governors. However, this is what it has come to. Investors cannot simply evaluate a company's fundamentals anymore -- they must also be able to forecast monetary and fiscal policy. And despite living in the D.C. area, I have no special insight into Bernanke's thinking. What I would say, however, is that we must get off this treadmill some day. We fear that jumping off at full speed could lead to injury.

Peace,

Michael