Focus on Japan Overshadows Fed Decision
by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
March 15, 2011
Key points
- To no one's surprise, the Fed kept interest rates at near zero and maintained its scheduled purchases of Treasury securities (also known as quantitative easing, or QE2).
- We're growing more concerned that the Fed is keeping interest rates low for too long, leading to potential problems down the road.
- With the market currently reacting to the tragedy in Japan and the ensuing market volatility, it's important to avoid acting hastily.
With the world's attention squarely on developments in Japan, The Federal Open Market Committee (FOMC) again held the line on its current monetary policy. The federal funds rate was held at the record low rate of 0-0.25%, while the FOMC members reiterated their intention to complete their previously announced purchase program of $600 billion in longer-term Treasuries (also known as quantitative easing or QE2) by the end of the second quarter.
With global uncertainty continuing due to the Japanese situation and continuing global tension in the Middle East and North Africa, the FOMC members felt it prudent to hold the line as they continue to assess the impact on the economies of the troubled areas.
The FOMC upgraded its view of the US economy, saying it's on "firmer footing." In order to attempt to strengthen the pace of the recovery, and especially the labor market, the FOMC members maintained their extremely easy monetary stance.
They noted this was possible due to still-stable inflation and expectations, despite the recent run-up in oil prices, which they believe is "transitory." They also noted continued "elevated unemployment," but with a slight upgrade, noting that the labor market is "improving gradually."
The Fed's dual mandateâmaximum employment and price stabilityâstands in contrast to the single mandate of the European Central Bank of low inflation. One consequence of these diverging monetary policies has been continued weakening of the US dollar. According to the Fed, the dollar hit a record low on a real trade-weighted basis in February.
Although a weaker dollar can be a positive factor because it makes US goods more attractive to foreigners, thereby helping American exports, there are also possible detrimental effects. It can have the opposite effect on American imports, and because we import many more goods than we export, higher prices for American consumers can result.
Also, global confidence in the US currency can start to be compromised, which may make some transactions more expensive for the United States. However, it's important to note that the dollar is still viewed as a "safe" asset. This has been reinforced by the flight to the dollar as concern over the nuclear situation in Japan has grown.
Also concerning to us is the asset inflation we've seen coinciding with QE2. While Fed Chairman Ben Bernanke has taken credit for boosting stock prices thanks to the easing program, he has flatly denied any role in the recent surge in commodity prices. We think it's unlikely that the continued flood of dollars in the market has had nothing to do with at least part of the run in commodities lately.
Unfortunately, Bernanke's largely right when he implies there's not a lot that he and the Fed can do about commodity price inflation. If the Fed were to implement a monetary-policy tightening process that's too rapid, it could run the risk of pushing the United States back into recession. As such, the Fed probably can't have a huge short-term impact on commodities.
While we agree with the Fed that inflation (especially at the core level) remains quite tame to this point, we continue to be concerned that the Fed is keeping interest rates too low for too longâsewing the seeds for inflation down the road.
Although current world events probably preclude the Fed from deviating from its current course, we've been advocating for some time that the financial emergency that justified such extreme monetary measures is long past, and slowly returning to a more normal policy would be a prudent course of action.
We remain concerned that another asset bubble may be brewing, much like what occurred the past two times the Fed was overly accommodative. Finally, while inflation isn't a problem right now, with so much money sloshing around, we fear it could accelerate relatively quickly.
Although we believe that the Fed has the tools to fight inflation should it become a significant problem, we worry that the Fed's waiting so long could portend that once it starts tightening monetary policy, the changes might have to be more severe.
The ongoing tragedy in Japan throws another wrench in the Fed's decision-making process. We've seen investors unnerved by reports of a possible nuclear meltdown, pushing the Japanese market down more than 15% in two days, while riskier assets of all sorts have also sold off.
Potentially helping the Fed's oil-induced inflation problem, we've seen the price of oil drop precipitously because Japan is the world's third largest importer of oil. As Japan emerges from the disaster, oil demand may be dampened.
We hasten to note that we don't believe the current events warrant an extension of the QE program because we believe the US economy is strong enough at this point to go without that support.
We urge investors not to overreact to the rising fear in the market. We have no ability to know how the situation in Japan will develop over the next days, weeks and months, but we're relatively sure that the Japanese people and economy will get through this disaster.
It's important to note that Tokyo remains largely economically intact and that the Bank of Japan is committed to providing ample liquidity to financial markets.
We'll continue to watch the ports to see how imports and exports are affected and how quickly they can get back up to speed. We believe it will be relatively quickly because Japan is very dependent on both for economic stability and many multinational companies have a large vested interest in making sure that their goods can be transported freely.
Even in an environment when some investors act out of fear, remaining calm is key to long-term investing success. Too often we've seen investors react in panic only to regret it later on.
Although we don't know what's going to happen in the short term, we acknowledge that more bad news coming out from Japan or the Middle East could dip markets lower and scare off investors until the volatility subsides a bit.
However, it's important to have a disciplined strategy for what you're looking for to get back into the market. The best time could be when things are still a bit uncomfortable and uncertain. Waiting for certainty will almost surely mean missing a large market move upward.
Importantly, we want to emphasize that stock investing is a long-term endeavor and we remain optimistic on the markets. The US stock market was overdue for a pullback, which should help correct some concerning sentiment indicators, indicating overly optimistic investorsâa contrarian signal. The United States continues to post strong economic numbers, employment is growing and skyrocketing commodity costs are starting to come off the boil.
In the long term, Japan will solve the nuclear-plant concerns and rebuild what's has been destroyed.
We can't be sure what will happen with the markets in the very near term, but history has shown that making fear-based decisions is rarely beneficial to investors. One of the keys to long-term investing success is remaining calm during times of uncertainty.
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