This Fed Will Fight

08/10/2011 10:44 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Yesterday’s policy change marks the end of efforts to appease critics, and the start of a new effort to salvage the recovery, writes senior editor Igor Greenwald.

We live in counterintuitive times.

A credit-rating agency downgrades US debt and investors bid it sky-high.

The economy shows every sign of double-dipping, and yet Washington has belatedly embraced Austerity Lite—which can only make a bad fiscal situation worse, both in the short term and the long run.

No wonder stocks are bouncing around like crazy. It’s tough to know which end is up, in markets randomized by trading algorithms, meddling sovereigns, and hedge-fund hysteria.

Still, how’s this for weird: the three dissenting votes on yesterday’s policy change by the Fed may be the most bullish “ tell” in this poker game.

The Federal Open Market Committee acknowledged what stocks had already signaled with their nosedive over the prior two weeks: that economic growth is faltering, with deflation once again a bigger worry than inflation.

It responded with a conditional pledge to hold the Fed funds rate near zero until “at least” mid-2013. It was that decision that drew three "no" votes from regional Fed presidents on the ten-member committee.

That was the most dissent seen within the Fed in 19 years, and it suggests the majority of the committee—starting with Federal Reserve Chairman Ben Bernanke—felt the need to act was too great to compromise.

As The Wall Street Journal notes today, Bernanke’s “resolve to push ahead suggests he won’t hesitate to tale bolder steps if he deems them necessary to help the economy.”

I believe it was that realization that drove yesterday’s massive late rally by stocks from the depths of despair.

The Fed may yet prove insufficiently powerful to contain the destructive forces tearing at a financial system that’s seen its many weaknesses cruelly exposed. But it won’t be for lack of trying, not under this chairman.

The Journal quoted a couple of former Fed insiders to bolster its thesis of “a shift toward a majority-rule, decision-making process at the Fed, in which a minority of officials worried about higher inflation…are marginalized.”

But even as the market was nose-diving yesterday on the mistaken presumption that the dissenters will somehow hamstring Bernanke, I kept thinking about what another recent Fed insider had just told the Washington Post.

“People overstate the influence of the hawks. They are a permanent minority. They’re really off on their own. There is a core of centrists that Bernanke could lead wherever he wants,” Joe Gagnon said.

Gagnon has spent 19 years of his 24-year post-academic career at the Fed, most recently as associate director for monetary affairs two years ago.

His views don’t represent Fed policy, of course, but they do offer good insight into “the range of policy tools available to promote a stronger economic recovery,” as the Fed put it yesterday, the ones it is “prepared to employ…as appropriate.”

So, Joe Gagnon, what should the Fed do?

“They should do a major QE3…I would start with $2 trillion and say that we have an unlimited capacity to do this and we will do however much is necessary to get the economy moving. Build the expectation that this is just a down payment…

"And they should talk about what they want to happen. They should want to get mortgage rates down, they should want to get the dollar down, get corporate bond yields down. Everyone in the country should now have a 4% mortgage.”

Gagnon has more prescriptions on the site of the Peterson Institute for International Economics, where he is a fellow, including suggestions that the Obama administration break policy gridlock by bypassing Congress, undertake the refinancing of all the underwater, non-delinquent loans guaranteed by Freddie Mac and Fannie Mae, and overtly adopt a weak-dollar policy to promote exports.

These are not matters within the Fed’s purview. But lowering long-term rates is, and in this regard the two-year no-hike pledge is already delivering.

NEXT: The Setup for QE3 and How to Profit


Even if Washington fails to extend the benefits to homeowners underwater on their mortgages, the Fed will spark a refinancing wave for those who bought homes in 2009 and 2010, fixed-income pro David Schawel writes. And the prepayments can be reinvested in long-term Treasuries, further driving down their yields, he notes.

Will Bernanke be satisfied with that? We’ll get a lot more insight into the Fed chairman’s thinking at the Fed’s annual policy symposium in a little more than two weeks.

But I would bet on further asset purchases, if only because the marginal political cost to these is low, and the burdens weighing down the economy great.

The conventional thinking has been that, after the Fed got savaged by critics over QE2, the threshold for QE3 will be high. But the debt crisis in Europe and the economy’s rapidly fading momentum appear to have already crossed the line, requiring a rapid response, in the mind of most Fed policymakers.

Further asset purchases loom as the logical next step. And I think at this point, the Fed has bigger worries than the feelings of critics who, as Paul Krugman writes, can’t be appeased.

What investments will profit the most from a period of falling interest rates and disappointing economic performance, similar to what we saw in mid-2008?

Hello, Annaly Capital Management (NLY) and other mortgage REITs with a solid track record. Hello, high-yielding energy MLP’s like Kinder Morgan (KMP) and Enterprise Products Partners (EPD).

Such high-dividend income plays were among the biggest gainers in yesterday’s rally, and are outperforming again in the early stages of today’s dunking. Their yield advantage over Treasuries grows wider by the day, and the Fed’s action yesterday almost guarantees that it will continue to do so.

Which is nice, but not as nice as a thriving economy would be for most of us. The Fed is so friendly, the non-risk-free yields so tempting, only because there is another financial and economic hurricane brewing.

We should be grateful to have a resolute leader (Bernanke) at the helm, and relieved that he’s no longer paying heed to the dissenters without or within.

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