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Craig Allen: Fed Paints Itself into a Bright-Red Corner

For the past eight months, since Sept. 13, the Fed has pursued a sustained bond-buying program, the third round of quantitative easing, or QE3.

The purchase of $85 billion in long-term securities each month brings the total purchased during QE3 to date to about $700 billion (and counting). But stock market gains from the low of around 1,350 on the Standard & Poor’s 500(November 2012) of about 23.5 percent through Friday’s close raise questions about the ability of the Fed to wind down QE3 without blowing up the stock market and/or the economy.

The dual mandate of the Fed, as stated by the Federal Reserve Act (amended 1977) is:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

In other words, the goals are to promote long-term growth of the economy and to maximize employment.

With the introduction of quantitative easing, and in particular QE3, the Fed’s mandate seems to have shifted to promoting stock market performance. In one sense, driving gains in the stock market could be seen as supporting economic growth and employment. Stock market gains improve consumer sentiment — as stocks go up, people experience the wealth effect, meaning they perceive an increase in their personal wealth, which gives them more confidence in the economy. The more confidence consumers have, the more likely they are to spend money.

Since about 70 percent of the growth in U.S. gross-domestic product comes from consumer spending, it is reasonable for the Fed to expect the economy to improve if sentiment improves as a result of positive stock market performance. An improving economy, driven by stronger consumer spending, could be expected to support employment growth, as well.

Historically, the Fed has been very hawkish on inflation, often sacrificing economic growth and even allowing the economy to dive into deep recessions to fight inflation. The massive infusion of cash into the economy through QE can create inflation by weakening the value of the dollar. However, due to the relative weakness of other currencies — namely the euro (the European Union), yen (Japan) and yuan (China) — the dollar has maintained its value and has even strengthened a bit recently. But the Feb must be concerned not simply with the short-term impact of QE but, more important, with what will happen as a result of this massive cash injection over the long term.

The U.S. economy is like the Titanic, not that it is a sinking ship, but because it is like a large ship with a small rudder — to turn it, you need to start your turn very early. To change the direction of the U.S. economy, the Fed must make changes at least two to three quarters before they need that change in direction to occur. This characteristic of the economy makes the job of the Fed extremely challenging. It is certainly not an exact science and the Fed (and you and I) are in uncharted territory in terms of the long-term effects of QE. We just don’t know what is going to happen to inflation, employment and GDP growth over the long term.

Perhaps the most significant short-term challenge the Fed will face is how to wind down the $85 billion it’s pumping into the economy each month. The longer it continues QE3, the tougher it will be to stop. One thing is certain, it will have to stop at some point. Estimates vary as the when the Fed will begin to taper-off the bond-buyer program, but it could happen as soon as next month. Most economists and Fed governors believe it will happen by September, if not before.

While Fed Chairman Ben Bernanke and company have tried to take the sting out of the end of QE3 by stating that they plan to be flexible about how they wind it down, and will stand ready to ramp it back up if necessary, the stock market has rallied to such extreme highs that any shift in policy is very likely to cause a sizable sell-off. In my experience, markets that have rallied for extended periods (the current bull market is more than 4 years old) and to rich valuations, represent the most significant risk of dramatic sell-offs, even when relatively minor changes to policy occur.

No one is in a better position to understand the potential for possible negative reactions to changing Fed policy than Bernanke himself. It is interesting to note that Bernanke, who is the architect of QE3, and most notably the duration of the bond-purchasing program, is signaling his intention to step down even before his term as chairman ends in January.

The Fed’s annual conference in Jackson Hole, Wyo., will be held Aug. 22-24. Jackson Hole has long been a high-profile platform for speeches by Fed chairmen. Since taking over the Fed in 2006, Bernanke has been the marquee speaker each year. In 2010, he used his speech to signal that the Fed could launch another bond-buying program, and as a result, stocks rallied.

In April, Bernanke announced that not only would he not be the keynote speaker, but that he would not attend this year’s conference at all. His most likely successor would be Janet Yellen, former San Francisco Fed governor. Her views are very similar to Bernanke’s, so it is unlikely that we would see a major change in policy. However, the fact that Bernanke wants to step down may indicate his growing concerns about the Fed’s ability to navigate between removing the stimulus program and maintaining economic growth and employment, all without spiking inflation.

The next Fed meeting is June 18-19 and Bernanke is scheduled to hold a news conference after that meeting, at which he will likely explain any planned policy shifts. The Fed is clearly aware of the very real possibility of a major stock market sell-off resulting from any reduction of QE3. After their last meeting, the Fed’s policy-setting committee stated that they were “prepared to increase or reduce” the purchases (of bonds through QE3) as labor market or inflation forecasts change. Clearly, they understand the impact any change could have on the stock market and the economy.

The Fed has clearly painted itself into a corner with the duration and magnitude of QE3. Its hope is that it can avoid any major negative reactions to changes in Fed policies by maintaining flexibility. Whether the Fed begins to wind down QE3 in June, September, sometime in between, or later in the year, we know it is coming to an end very soon. The real question is: Will the Fed be able to maintain economic and employment growth over the long term, avoid inflation over the long term, and avoid a major stock market correction or crash?

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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