The Mandate that Killed Your Portfolio

I have always wanted a rich uncle, like Rich Uncle Pennybags.  One who would bail me out every time I maxed out my credit card or put $10,000 on Prospective to win the Kentucky Derby (Prospective went off 58-1 at this past weekend’s race and finished 18th).  But I don’t.

Fortunately, the global banking system does, in the form of giant printing presses... I mean, central banks.  The money has flowed in the form of quantitative easing, twisting, long term refinancing operations, and of course outright bailouts.  The markets have lapped it up over these past years, bursting higher at any indication that the green was going to flow.

But the question remains:  Did central banks -- and, in particular Rich Uncle Ben’s domain, the Federal Reserve -- overstep their bounds?  Have they sacrificed the good of the many for the benefit of the few as a result of its dual mandate?
 
It's important to remember that the Federal Reserve has a dual mandate, as stipulated in the “Federal Reserve Reform Act of 1977.”  It concludes by directing the Fed to “... promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.”

Stable prices and moderate long term interest rates usually get lumped together to describe inflation, so the dual mandate is employment and inflation.  House Bill 4180, the “Sound Dollar Act of 2012” proposed by Rep. Kevin Brady (R), looks to strip the Fed of its goal of maximum employment and allow it to focus on inflation.

This was the focus of Tuesday’s hearing by the Domestic Monetary Policy and Technology Subcommittee (bet you didn’t even know there was such a committee) which was chaired by ardent Fed critic Ron Paul.  Paul was proposing another bill that would abolish the Fed and return the US to the gold standard -- that wasn’t discussed for long.

Instead the focus was on H.R. 4180, which proposes a single mandate for the central bank and an inflation target.  The bill would have two benefits:

1. Investors would know exactly what to expect from the Fed, because it requires their methodology be clearly spelled out.  As a result, transparency would increase and discretion on interest rates would be largely eliminated in favor of a rules based policy.
    
2. The Fed, which has acknowledged that employment is largely beyond the scope of monetary policy, would not be tempted to keep rates unnecessarily low for fear of disrupting short term employment.

Let me address the second point first.  During the housing boom, unemployment was at or below 5% for some time as a result of the explosion in construction jobs and all the ripple employment that came from that.  Inflation was not running hot, but the economy didn’t need the lower rates.  A nudge higher on short term rates may have helped tame demand.

Additionally, the Fed could have used its regulatory powers to crack down on fraudulent lending practices, but that might have negatively impacted jobs, so it was overlooked.

When the housing bubble imploded, banks started collapsing.  Since inflation wasn’t an issue, the Fed took interest rates to zero and began engaging in “unconventional” easy money, in the name of getting the economy and jobs back on course.  Some easing would have been necessary because both GDP and inflation were below trend, but it is unlikely that the Fed would have felt the need to go to such extremes without the dual mandate.

Simply put:  Less focus on employment and more oversight of member banks could have mitigated the devastation that occurred to global portfolios.
 
The positive impact from excessive easy money on employment is negligible at best, and the verdict on inflation is still out from the Fed’s perspective, but we have seen risk assets soar.  Oil, gold, and stocks have all benefited from low interest rates... because there are few alternatives. 

At the core level, inflation has been more or less below the target of 2%, but the headline number, which includes food and energy, is higher.  The Fed has chosen to target 2% on the headline number, but couched that by saying that some additional inflation is acceptable if it is a result of transitory factors like the price of oil.
 
The bottom line is that based on the Taylor Rule (which I won’t get into, but is likely to be a guideline for an inflation targeted monetary policy), interest rates should be higher.  Pick any of the recent inflation numbers and GDP growth rates, and the Fed funds rate should be around 1% rather than the current 0%.
 

One percent is not going to get savers particularly excited, but slightly higher interest rates and a clear rules-based policy can help businesses and individuals alike with planning.  Similar to the argument I made a few weeks ago regarding taxes, clarity goes a long way toward getting the economy going.

When investors and businesses don’t know when, how, or if the next government intervention is going to take place or what short term impact it will have, they hold off. 

A revision of the Fed mandate to the single goal of price stability would go a long way toward getting the economy back on track by...

• Removing uncertainty;
• Helping to enforce the independence of the Fed by eliminating potential political pressures on monetary policy that result from having employment equally in focus (ok, I may be dreaming on this one), and...
• Giving savers at least a little something.

So keep an eye out for developments on this front, because although the markets may initially react negatively to the withdrawal of monetary "crack", it is reform that will help the economy and the markets in the long run.

Ed Pawelec
Contributing Editor
Price Shock Trader