The Fed Tosses the Ball to Congress

The June Meeting

At the June 2010 meeting of the Federal Reserve, the officials concluded that the economic outlook "had softened somewhat." That was an understatement if there ever was one. In fact, one-half of the officials thought that the risks to growth "had moved to the downside." Furthermore, the Committee went on to say that it might take as many as five to six years for the economy to recover. Frank McGuire, reporter for Moneynews, thought this was a "slightly more dimmer" view than the Committee had in its April meeting. Boy, that seems like more than just "slightly."

The Fed also trimmed its forecast for GDP growth in 2010 to between 3% and 3.5%. That seems optimistic when compared with projections of major central banks like Wells Fargo and Bank of America. Their projections are for 1.5% and 2.7% respectively, for the year. Nouriel Roubini's forecast is for 1.5% for the second half (consensus is at 2%). He has been accurate in a number of instances, and if you remember, he was one of few prominent economists predicting the 2008 Great Recession. The Fed was making their changed 2010 forecast at a time when Europe was undergoing their debt crisis, the stock market was volatile, and unemployment remained. Since that time, one could argue not much has changed except the sentiment.

The Committee decided to keep interest rates at zero for an "extended period" and to consider other stimulus techniques, such as purchasing more bad mortgage loans with the money received as payments on the existing mortgages it holds on its balance sheet. The Fed can also eliminate the interest rate they now pay on member bank deposits, thereby encouraging banks to lend more. They are not worried about fighting inflation, and why they should they be? The last CPI report showed year-over-year inflation at just 1%. They would only consider further action if the economy worsened. Well, guys, how worse can it get, short of either a full-blown recession, or worse, a spiraling deflation?

The July 21-22nd Senate Banking Committee Testimony

On Wednesday, July 21, Federal Reserve Chairman Ben Bernanke testified at the semi-annual Senate Banking Committee that the economic outlook was "unusually uncertain", to quote the esteemed doctor.  That should have been no surprise to anyone, but apparently investors were surprised, as they took the DOW down 109 points and the S&P 500 down 14.

Here are the highlights of his testimony:

             ►  the economy will show moderate growth in 2010 but the outlook was

                  unusually uncertain.

            ►  the Fed has three options for supporting the economy but each one has

                   drawbacks and potential costs.

            ►  the labor market remains a key worry and they expect the unemployment

                  rate to slowly drop to a range of 7% to 7.5% only at the close of 2012.

            ►  federal budget deficits are appropriate for this weak economy but that

                   additional fiscal support from Washington could help.

            ►  the best approach would be to maintain some fiscal support in the near

                   term but to combine that with serious attention to "significant fiscal

                   issues" for the United States in the medium term; it's not either or;

                   Washington needs to do both.

            ►   Extending the Bush tax cuts is one way to provide fiscal support.

Bernanke testified that the time had come for the economy to be given a boost. While repeating that no second recession is in the cards, he left no doubt that the Fed would act if the economy did not improve, particularly in the labor market.

The Bombshell

On Thursday, gentle Ben dropped a major bombshell on the Democratically-controlled Congress that is looking to increase taxes in addition to letting the Bush tax cuts expire. Bernanke said this: "In the short term I would believe that we ought to maintain a reasonable degree of fiscal support, stimulus for the economy." He went on to say that the Bush tax cuts should be extended. Reaction was immediate; the DOW shot up 202 points and the S&P 500 finished the day up 24. The reason had more to do with some great profit reports as well as the extension hopes.

Is it going to happen or is the market on a short-term joy ride? Three Democrats came out with statements basically supporting the extension.   President Obama has not backtracked on his campaign promise, nor  do we expect him to do so. Whether he would veto any legislation extending the cuts is another matter, but we wouldn't count that option out. Speaker Pelosi  is against benefiting the rich, as she characterizes the situation. House Majority Leader Steny Hoyer seems to be toeing the party line also. Key cabinet members such as Larry Summers and Timothy Geithner are also against the extension. One compromise being discussed is to only extend the tax cuts for those making $250,000 or less. Anyway you look at it, a battle is brewing. Chairman Bernanke ventured that Congress should find funding so that the extended tax cuts wouldn't add to the deficit. There probably was no better way to kill the idea then to suggest that Congress find funding for a tax cut for the rich, the same Congress which could not fund the extended unemployment benefits. We just think the market is getting just a wee bit too happy over this.

However, bullish investors seem to be grasping at anything to keep the market rally going. They can argue all day about the insanity of raising taxes during a recession, but in the end, the arguments could fall in the face of the need to cut the budget deficit as well as the Democratic argument that the rich should pay more, progressively, than the poor. Robin Hood arguments aside, the potential increase in taxes in 2011 will hit small businesses whose tax structure is typically a flow-through entity, such as a partnership or an S corporation. If most of these businesses have profits in excess of $250,000, the expiration of the Bush tax cuts could restrain employment growth.

Our Opinion

From a practical point of view, the Federal Reserve may have fewer tools left to stimulate the economy then might seem the case, Chairman Bernanke's testimony notwithstanding. The rates can't go lower than zero, at least we don't believe Ben has an engineering strategy that could create that. But he did hint that the Fed might publicly declare that rates would stay low until late 2011. We also don't believe reducing to zero the interest it pays banks on their deposits with the Federal Reserve will help banks increase lending to small businesses, loans that are now considered more risky than before the Great Recession. The Fed could buy Treasuries in the open market up to $1 trillion or so to bring the 10-Year note interest rate to practically zero  (it's now 2.99%). There's a real question whether that would be stimulative. People aren't investing in houses now at 4.6%. Why would they do it at 1.6%? Won't that policy severely hurt bank profits and risk more bank failures?  There's also a risk that inflation could start up again, although that would be a long-term risk. Would the Fed know when to stop the stimulus?

We think it is possible that the Chairman's suggestion that Congress adopt some funded fiscal stimulus could be seen as a veiled threat. If you Congress don't act, then we at the Federal Reserve will buy up to x, whether it be $1 trillion or some other figure, and expand the money supply with attendant risks of inflation down the road. We won't take responsible for consequences either.

To conclude, Chairman Bernanke's testimony before the Senate Banking Committee last Wednesday and Thursday was a reminder that the economy is still in a weak recovery mode. We think the med-term slow-growth theme we have been espousing is a valid one and investors need to adjust to that realization.

John A. Epeneter, CPA/PFS, CFP®, CFS, CCPS, Master of Science in Financial Planning.  Copyright © July 2010.