Brian Jacobsen

Fed policy: From fears of too much to too little

AdvantageVoice® Blog—2-21-13
Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

By all appearances, the equity markets reacted negatively to the release of the Federal Open Market Committee’s minutes. Some Fed officials have been publicly questioning the costs and benefits of continued asset purchases by the Fed. The minutes from the January meeting revealed a lot of what has already been said in myriad speeches by Fed officials: The labor market is still sluggishly improving, fiscal policy debates have increased economic uncertainty, and it isn’t the unanimous opinion of the FOMC members that its accommodative policy is appropriate. This is all old news. What may have been new news was that the skeptics are increasing in number and volume. I’ll call these the “QE-Skeptics.” These members are skeptical that either:

  1. When the time comes, the FOMC can shrink its balance sheet in a way that doesn’t disrupt the financial markets.
  1. Even before it comes time to shrink the balance sheet, the cessation of bond purchases could disrupt the markets.

I don’t think it was ever reasonable to say that the Fed would keep expanding its balance sheet forever (the so called, “QE-infinity” view). The Fed was simply engaging in “QE-for now.” Once economic conditions got to the point where the members agreed it was appropriate to stop buying bonds, it would do so. It’s just that the time wasn’t now. The Fed minutes from the December meeting showed market participants that the bond buying would end at some point, probably at the end of 2013 or beginning of 2014. The Fed would then likely keep the target for the federal funds rate at effectively 0% for a while longer. The minutes from the January meeting probably shifted expectations of when those bond purchases would stop. Instead of stopping at the end of 2013, maybe they will stop sooner. I doubt that, though.

There is enough policy and economic uncertainty for the balance of the year, and there is still only one dissenter of record, leading me to believe the Fed’s plans haven’t changed since its December meeting. The Summary of Economic Projections (SEP) that the FOMC releases at every other meeting will likely be updated at the March 19-20 meeting. Also, the policy statement itself may be updated to give the FOMC more flexibility to vary the pace of asset purchases. Other than that, I don’t think the Fed’s accommodative policies are going to change much. If anything, the FOMC may contemplate increasing the pace of asset purchases to counteract some of the policy uncertainty and to help keep mortgage rates down. Then, perhaps by midsummer, the Fed might begin to taper off its asset purchases.

But what about when the Fed stops expanding its balance sheet? What’s its “exit strategy”?
I think it will simply let its balance sheet shrink naturally as the various assets it holds mature. It will likely start by not reinvesting proceeds from the assets. Then, if financial conditions warrant it, it could consider selling assets. There is no reason the Fed needs to jump directly from buying assets to selling them. It can always hold onto them.

But what if interest rates rise and the Fed begins to lose money on the assets it holds?
My answer is, “So?” The Fed is not a profit-maximizing entity that has to worry about whether it lost money on its assets or not. Because of an agreement the Fed has with the Treasury, the Fed could simply create a deferred asset on its balance sheet (kind of like a deferred tax asset that you see on many corporate balance sheets) that allows it to not remit profits to the Treasury. As it is, any profit the Fed makes on its portfolio is sent to the Treasury. If the Fed suddenly has a loss on its balance sheet, it will be able to stop those payments and not resume them until it digs itself out of its hole. It’s all plain-vanilla accounting stuff.

Market prices are not reflections of some sort of average opinion of investors. Market prices are the product of the actions of those who were actually buying and those who were actually selling at that time. The decline in the equity market was probably led by those who thought the Fed’s pumping of liquidity into the system was the main support for high equity prices and that flow of liquidity may end sooner rather than later. On the other side, for every share that is sold there is a share that is bought. Many of those buyers probably recognize that there are some good fundamental reasons for stock prices to be where they are. As you can probably tell by the way I wrote the preceding few sentences, I tend to agree with those who are looking more at the fundamentals than those who are looking at the Fed.

The views expressed are as of 2-21-13 and are those of Chief Portfolio Strategist Brian Jacobsen, Ph.D., CFA, CFP®, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.


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