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Fed Up

Adam M. Grossman  |  July 12, 2020

LAST WEEK, I talked about some of the unsettling trends in the financial markets. In that article, I focused on the role of brokers and day traders, and noted that it takes two to tango. But it turns out the dance floor is quite a bit more crowded than that.

Yes, brokers and day traders are doing their part, but there’s another set of actors who are less visible but a whole lot more influential. As you ponder your investments, I think it’s important to understand who they are and the role they’re playing.

A while back, I was in an Uber. The driver began to share some of his views. Among other things, he said the Federal Reserve was privately owned by the Rothschild family of Europe. While this sounds crazy—and it is—it also turns out to be a widespread conspiracy theory. One of the reasons for that, I think, is that the Fed is unique. Both its role and structure aren’t easy to understand. But it’s important to try because, acting behind the scenes, the Fed’s impact is significant—and not always positive.

The Federal Reserve’s mandate is twofold: to minimize unemployment when the economy is weak and minimize inflation when the economy is strong. To accomplish these objectives, the Fed has several unique tools at its disposal. Primary among them are the ability to influence interest rates and to effectively print money. In my view, the Fed has gone off the rails in its use of both tools.

Interest rates. Because the Fed governs the rate at which banks lend to one another—known as the federal funds rate—it ends up indirectly controlling all other interest rates. This is an important lever because low rates spur economic activity. Whether it’s an individual buying a car or a house, or a company buying equipment, lower rates drive economic activity.

Historically, in normal times, the federal funds rate has averaged about 5%. During the 2008 financial crisis, however, the Fed took the unprecedented step of dropping the rate to nearly zero. It remained near zero until 2015, after the economy had regained a healthy footing. Between 2015 and 2019, the Fed raised rates, but only gradually. As a result, when the coronavirus hit, the federal funds rate was still only in the 2% to 3% range. This left Fed governors no choice but to drop the rate back down to zero, which is where it stands today.

Don’t get me wrong. I’m glad that the Fed acted quickly to lower rates this year. The problem: It had been too timid in raising rates earlier and, as a result, found itself boxed in. Rates were already so low that it had little room to maneuver, unless it opted to go below zero—which is the odd situation today in parts of Europe.

Printing money. In late March, as stocks plummeted, the Fed announced a set of additional policies to stimulate the economy. Not coincidentally, the day it made this announcement was the day that the stock market turned around and began the fastest recovery on record. Here’s what Fed Chair Jerome Powell said at the time: “[W]e’re not going to run out of ammunition, that doesn’t happen. We still have policy room in other dimensions to support the economy.”

What exactly did he mean by “policy room in other dimensions”? He was talking about printing money. While the Fed doesn’t technically print money—that’s the job of the Treasury—it has the power to create money out of thin air. Like God dropping dollars into people’s bank accounts, the Fed can and does create money, using it to buy investment assets to help stimulate the economy.

What’s wrong with these policies? Aren’t zero rates and printing money great for everyone? My concern is that these policies distort economic behavior. We’ve seen it in the past. We’re seeing more of it this year, and I worry that it will continue as long as these policies persist. Here are four areas where the impact seems most pronounced:

1. Individual investors. Low rates make bonds less attractive to investors, causing them to scratch around for alternatives. Low bond yields cause some investors to pursue riskier kinds of bonds, while it prompts others to decamp from bonds entirely in favor of stocks, where dividends today can be higher than bond yields. Either way, these low rates are coercing investors into riskier investments.

2. Stocks. It may surprise you to know that Apple, which earned $55 billion in profits last year, borrows money. In fact, it has more than $100 billion of debt. Why would Apple borrow? In my view, it’s because of super-low rates, compliments of the Fed.

What does Apple do with all this borrowed money? In large part, it uses the money to buy back its own stock, which helps drive the stock higher. Over the past four quarters, Apple has repurchased $73 billion of its own shares. And Apple isn’t alone. Many companies pursue this strategy. The result is that the Fed’s policy of rock-bottom rates has been driving the stock market higher—artificially, in my opinion.

3. Consumers. Basic economics states that printing money will ultimately cause inflation. But inflation has been historically low over the past decade, causing some people to ask whether this traditional relationship no longer applies.

This has even given birth to a way of thinking called Modern Monetary Theory (MMT), which postulates—in simple terms—that the government can and should print as much money as it wants as long as it doesn’t cause inflation. An MMT proponent, in fact, recently published a book called The Deficit Myth. Not surprisingly, MMT has gained adherents on both sides of the aisle in Washington, because it says that there’s no longer a tradeoff between cutting taxes and social spending. It’s a politician’s dream.

There’s just one problem: MMT is premised on the observation that inflation has been low for many years, despite Fed policies that should have been inflationary. But as my actuary friend Ross points out, the reality is that there has indeed been inflation—lots of it. It’s right under our nose. It just hasn’t shown up in the official figures because it’s impacted prices unevenly. Just look, however, at the price of homes or college tuition. In fact, anything that can be purchased on credit has seen prices go through the roof. That’s because it’s been so cheap to borrow. While the MMT crowd might think deficits don’t matter, consumer debt definitely does. In short, the Fed’s low-rate policies have put consumers deeply in debt.

4. Inflation and the federal debt. The federal debt had already been on a dangerous trajectory when the coronavirus hit. Together with this year’s stimulus spending, it’s at an unspeakable level. According to MMT proponents, we shouldn’t worry. But the data on which their theory rests is awfully thin.

The author of The Deficit Myth, for example, points to Japan as a case study. Japan has pursued policies similar to the Fed’s and has also experienced low inflation. But it isn’t conclusive to point to one other country in one single time period. The author also overlooks the concept of a tipping point. What if inflation is low for now, but something triggers it down the road? If inflation and interest rates head higher in the future, we’ll all be looking at paychecks that don’t go as far or at tax rates that are higher, and perhaps both.

What’s the solution to all this? Unfortunately, there is no magic bullet, and that’s part of the problem. It’s forcing investors to choose between lower yields and higher risk, with not a lot of great alternatives. Still, the only and best path, in my view, is to maintain a simple, low-cost, diversified portfolio. Rebalance consistently and look for ways to protect yourself from higher taxes down the road. Most of all, don’t feel coerced into chasing hot stocks or higher-yielding, higher-risk investments. Instead, stay the course with a sensible portfolio—and hopefully, over time, good sense will again take hold in Washington.

Adam M. Grossman’s previous articles include Two Reasons to WorryToo Slow and Sticking With It.  Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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