Tags: Federal Reserve | Quagmire | Economy | markets

Fed Is Caught in a Trap and Can't Get Out

Fed Is Caught in a Trap and Can't Get Out

By    |   Friday, 22 April 2016 07:05 AM EDT

“It is easier to get into something than get out of it.”  That’s a quote from former Secretary of Defense Donald Rumsfeld regarding military intervention.  He’s referring to the fact that it’s relatively easy to send the military into some foreign conflict, but it is infinitely more difficult and complex to bring the troops home.

When the military gets involved in a conflict it involves itself in the balance of power of the country.  After the conflict ends, the removal of these forces disrupts the new power structure that was created.  Withdrawing the troops threatens the new peace and stability and could undo the very reason for the intervention in the first place.

In fact, we still have troops in Germany, Japan and Korea.  Places where troops have pulled out have been for the most part disasters.  But I mention this not to dwell on military history but to point out that the same dynamic applies to other areas as well, namely Central Bank intervention.

Since the financial crisis, the Federal Reserve Bank has intervened in the US economy with far greater scope and scale than another other time in history.  In an effort to stimulate economic growth, the Fed, through its bond buying programs, injected over $4 trillion into the banking system and has kept the benchmark short term interest rates near zero percent for almost eight years.  That was the easy part.

Showering the system with money and lowering interest rates was relatively popular. 

After all, the liquidity and low interest rates were great for the stock market.  With no place else to go to earn a decent return, money piled into the market and the S&P 500 soared 200% in the six years following the financial crisis.  

The Fed will now have to reverse the policies that were largely responsible for driving the market higher.  This is the hard part.  Nobody really knows what the affect will be.

The Fed has already begun to pull back.  The bond buying program was ended in late 2014.  At the end of last year, the Fed began a process of “normalizing” interest rates to near historic levels and raised the Fed Funds rate by 0.25% from the near zero level, where it had been since 2008.

The Fed announced its intention last year to undergo a series of four 0.25% rate hikes in 2016.  But things are getting awfully dicey.  After the tiny rate hike in December the market didn’t react too well.  The S&P 500 plunged more than 10% in the first six weeks of the year.

Because of the volatile market and the struggling global economy, the Fed paired back on its plan to raise rates from the announced four times to perhaps two times. Debt markets are skeptical that the Fed will raise rates at all this year.  With no rate hike on the horizon, the indexes have come roaring back and are now high for the year.

Let’s review.  Fed policies of aggressive bond buying and near zero interest rates drove stock prices higher after the recession.  Since the bond buying program ended in late 2014, the market indexes have gone nowhere.  When the Fed tried to abandon the policy of keeping rates artificially low and began raising interest rates, the markets crashed.  When the Fed pulled back from its plan to raise rates, the market soared.

The Central Bank has gotten itself into quite a pickle. It’s seems unlikely that they can normalize rates (and withdraw its influence on the markets and economy) without crashing the market.  I don’t think the Fed will ever muster the political will to go ahead and raise rates anyway. 

It looks like the Fed’s influence on the markets and economy will remain for a long while. 

This could be a huge problem down the road if inflation ever becomes a problem.  The Fed could ultimately have to decide between stopping inflation (by hiking rates) or a crashing market and recession. 

I bet it chooses inflation.

Tom Hutchinson is a Wall Street veteran with extensive investing and finance experience.

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"It is easier to get into something than get out of it." That's a quote from former Secretary of Defense Donald Rumsfeld regarding military intervention.
Federal Reserve, Quagmire, Economy, markets
Friday, 22 April 2016 07:05 AM
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