New York: 07:13 || London: 10:13 || Mumbai: 15:43 || Singapore: 18:13

Global Outlook

3 Fed Myths Debunked

April 2, 2014, Wednesday, 17:20 GMT | 13:20 EST | 21:50 IST | 00:20 SGT
Contributed by eResearch

For years now investors, analysts, pundits, plumbers and car mechanics (add any profession you’d like) have been arguing about the merits of what the Federal Reserve’s actions have done to the economy and the consequences they will lead to.

You can argue about the Government’s intervention and role they played leading up to the financial crisis, but I believe the Fed acted appropriately at the beginning to keep the crisis from getting worse than it did. The argument now seems to be about what the Fed’s exit strategy will be and the consequences of their actions over the last five years will lead to.

Many investors, incorrectly, believe the Fed’s actions will have dire consequences, even though their initial action probably saved the economy from more damages. There are more incorrect beliefs but I’ve listed three of the most common ones I hear.

When the Fed Prints Money, It Increases Money Supply

What the Fed has been doing with QE through QE3 is printing money. They are buying bonds with the goal of the money they are spending flooding the economy with cash and increase credit. Again, the goal is to get corporations and especially banks to spend this money. They want corporations to buy new technology and equipment to replace outdated technology and equipment they have been making do with since the recession.

The goal was for banks to start increasing their lending and getting the money to people who want to borrow to start small businesses, buy homes and other big ticket necessities. Unfortunately it has not worked out this way.

The Fed has no way to control money supply. Banks control approximately 90% of the money supply and the banks have nOt been lending, and thus, the money supply has not been growing for all these years QE has been in place.

QE Is Why the Stock Market is Up

When the Fed buys U.S. Treasuries and mortgage-backed securities, they are buying them mostly from banks. The problem with this is these banks are just re-depositing a vast majority of that money back into the Fed as excess reserves. The remaining money, for the most part is being invested in slightly riskier fixed income assets. These riskier assets are not equities because banks don’t want to get burned again like they did in 2008 and almost went out of business, like Bear Stearns and Lehman Brothers.

What QE has done is lift the confidence of investors by essentially saying “we won’t let 2008 happen again, so don’t be afraid.” It’s more psychology than it is a fundamental reason for the market going up.

Of course, psychology isn’t the only reason the market has soared in the last five years. Stocks were incredibly cheap at the beginning of 2009 and we experienced the very common rebound effect. Stocks hit a bottom and when all the bears capitulate, the market roars back to life and experiences a huge upswing. That rebound effect is over. Fundamentals have taken over and are the main driver behind the advance in equities. GDP has grown for 5 straight years, corporate earnings are up and the market isn’t oversold.

The Fed is Going to Create Hyperinflation

With the Fed going on this bond-buying spree and trying to flood the economy with cheap money, surely inflation will follow. But, inflation is running just above 1%. So, how do those who predict high inflation justify their prediction? They say “it’s coming , someday.” I've even heard some say inflation is here now and the Fed is "cooking the books." That seems like a tough proposition since we all know what we pay for everything and prices don’t seem to be moving in an upward trajectory. That'd be a pretty big conspiracy to pull off with a lot of moving parts, it just seems too far-fetched.

There really doesn’t seem to be any concern about inflation now or in the next few years. Afterall, all the “cheap money” being pumped into the economy hasn’t really made its way into the economy, it has been stuck at the banks. They are waiting for the yield curve to steepen so they can make more money lending on the long end and borrowing on the short end.

We will see inflation pick up, and that’s a good thing. It’s better than deflation. However, since QE hasn’t done what it’s supposed to do, I believe inflation will increase at a steady, measured pace that the market can easily digest.

Putting it All Together

The Fed has received a few accolades for avoiding a depression but in the last couple years they’ve felt more heat about the unintended consequences of what QE and leaving the short rate near zero will bring. But, there is only so much the Fed can do. If banks don’t want to lend, they won’t. Printing money in and of itself won’t cause hyperinflation. They don’t control the money supply, they only provide the tools for the economy to recover. The Fed is an easy scapegoat and they’ve made big mistakes in the past, but as of now, I haven’t seen them do anything catastrophic.