Throughout the Great Recession, the Federal Reserve has helped to prop up the U.S. economy to the tune of well over a trillion dollars. One of the biggest uncertainties this year concerns when and how the Fed will take away the “punch bowl,” as some are calling the pool of liquidity that’s kept the economy afloat. Investors will be looking to next week’s meeting of the Federal Open Market Committee for clues on how Chairman Ben Bernanke and his associates will cede their role in supporting the economy to the private sector, “one of the most challenging tasks we’ve seen in several generations,” says Anthony Chan, chief economist for JPMorgan Private Wealth Management and former economist at the New York Fed.
The Federal Reserve used two main methods to support the economy: controlling short-term interest rates and buying up assets in a process known as “quantitative easing.” Both pump money into the system: Low interest rates stimulate lending, while the Fed’s purchases of Treasury bonds and mortgage-backed securities funnel money directly to the banks that sold them. Now, the Fed has to reverse course. It has already stopped its purchases of Treasury bonds, and its purchase of mortgage bonds is scheduled to stop in March. The Fed’s withdrawal from the mortgage bond market could raise mortgage rates, putting a damper on economic growth. And the prospect of raising short-term interest rates is an even dicier proposition. If the Fed raises rates too fast, it could slow growth. But if it raises rates too slowly it could lead to rampant inflation. “They’re caught between a rock and a hard place,” says Brian Beaulieu, CEO of the Institute for Trend Research, an economic forecasting firm. What’s more, Congress might use any slowdown that follows an interest rate hike as an opportunity to try to rein in the independence of the Fed, Beaulieu notes.
Investors will scrutinize the language of the Federal Open Market Committee’s statement, to be released next Wednesday, for clues on how long short-term interest rates will remain at their record lows of between zero and 0.25%. Last month’s statement said economic conditions would likely warrant “exceptionally low” rates for “an extended period.” The mere absence of the phrase “for an extended period” in this month’s statement could roil the bond market, says Ken Volpert, head of Vanguard’s taxable bond group. Bond traders would drive prices down and yields up on worries that inflation loomed (inflation hurts bonds by eating into yields).
Once the Fed starts to raise rates, stocks could also come under pressure. Historically, the periods when the Fed pauses after lowering interest rates have been good to stocks. In the five prior periods when the Fed went on hold for more than a year following rate decreases, the S&P averaged a gain of 33.2%, according to Bespoke Investment Group, a money management and research firm. Once the Fed began to raise rates, however, the S&P 500 declined in the next three months by an average of 5.5%, with only one of the five prior periods resulting in a gain, Bespoke says.
So keep your eyes on the Fed. We could be in for a choppy ride.
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"Active Trader: Taking Away the Punch Bowl" w/ Brian Beaulieu, CEO of the Institute for Trend Research (SmartMoney) http://bit.ly/6Px4WE
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