THE FED’S TOUGHEST JOB LIES AHEAD! September 25, 2009

Being Street Smart

Sy Harding

THE FED’S TOUGHEST JOB LIES AHEAD! September 25, 2009.

Talk that was simmering before, about how the Fed will manage the eventual withdrawal of its massive economic stimulus programs, intensified this week when the Fed’s statement after its FOMC meeting was even more positive about the economic recovery than its previous statements.

The Fed said “Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be stabilizing.”

However, the statement also included enough cautionary phrases to keep analysts guessing as to just how optimistic the Fed really is, as the statement also said; Household spending “remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on investment and staffing.”

As was expected, the Fed left its Fed Funds Rate at the extreme low range of 0 to .25%, and said “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

It also said it will extend its program of buying $1.25 trillion of mortgage-backed securities to the end of March, 2010. (The program was scheduled to end December 31). But it did not increase the total amount of purchases, so to stretch them out an additional three months, “The Committee will gradually slow the pace” of those purchases, so they will gradually end by next March, instead of abruptly ending at the end of December.

As previously announced, it also said it will end its program of buying up to $300 billion of Treasury securities by the end of next month.

So an extremely important debate has begun.

Sung Won Sohn, a respected economics professor at California State University says, “The Fed’s exit strategy from the stimulus efforts is in motion.”

Former Fed vice-chairman Alan Binder says, “Nobody at the Fed thinks now is the right time [to begin an exit strategy]”.

But Federal Reserve Governor Kevin M. Warsh said on Friday that unwinding of the Fed’s “unconventional policy tools” used to address last year’s onset of the financial crisis, “likely will need to begin before it is obvious that it is necessary, and possibly with greater force than is customary.”

The Fed’s decision on when and how to reverse the massive and unprecedented actions it took to salvage the economy will be as important to the economy as were the rescue efforts, and just as difficult to handle with desired results.

The $trillions of dollars involved this time, and the unusual manner in which it was flooded into the system, would make removal of the medicine without causing withdrawal pains for the economy difficult enough.

Coordinating the withdrawal with other agencies like the Treasury Department, FHA, and FDIC, which have $trillions involved in their own bailout programs, adds an especially tricky additional level of difficulty.

To that you have to add that the crisis and the unusual bailout efforts were global in nature, and withdrawal of the medicine will have to be coordinated globally, among a group of nations which each have their own agendas.

Meanwhile, global central banks, including the U.S. Federal Reserve, have a dismal record when it comes to either recognizing the need to stimulate the economy in time to prevent recessions, or withdrawing the punchbowl in time to prevent inflation and asset bubbles.

There have been nine official recessions since 1955. In every case the Fed’s recognition of the situation, and efforts to stimulate the economy to prevent a recession were too late and too slow to be effective.

Most recently, it did not see the bursting of the real estate bubble in early 2007 as a problem for the economy, saying as late as the spring of 2008 that it would be confined to the housing industry, and result only in a slowing of economic growth, but not a recession. Behind the curve? One of the most severe recessions in history had already begun in December, 2007.

In the other direction its efforts to remove the punchbowl to prevent a surging economy or stock market from developing into a dangerous bubble, or raging inflation, have not been any more timely, or impressive.

It didn’t begin raising interest rates to slow the surging economy in the late 1990s until June 30, 1999. It then raised rates in small increments six times, and was still raising rates in May, 2000, several months after the stock market bubble had burst and was bringing the economy down on its own. With the severe 2000-2002 bear market and the 2001 recession then underway, it did not begin cutting rates again to try to stimulate the economy until January 3, 2001. And by then it was so far behind the curve it had to cut rates 13 times, not stopping until June 25, 2003, when it was finally satisfied the economy was recovering from the 2001 recession.

So with its next job made so much more difficult by the unusual conditions created by this massive financial crisis, recession, and bailout effort, it does have tough work ahead, in even determining when it should begin unwinding the stimulus, let alone how to do it.

Obviously acting too soon would risk sending the economy back down into a double-dip recession. Yet, leaving the massive stimulus conditions in place too long would almost surely result in runaway inflation.

As Fed Governor Warsh said on Friday, “The stakes are high. . . . We are in a critical transition period of still unknown duration. . . .Judgments made by policy makers in the current period are likely to be as consequential as any made in the depths of the panic.”

The stock market may be sensing that uncertainty, having been decidedly uncertain itself almost from the minute of the Fed’s FOMC statement on Wednesday.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website www.StreetSmartReport.com, and the free daily market blog, www.syhardingblog.com.