Sunday, August 25, 2013

Fed's Dilemma: Stop QE, Continue or Increase!!

Recently we have hearing a lot about Federal Reserves tightening the monetary policy towards the end of this year. This assumption is based on clues coming out of the FOMC meetings. Latest news came out on Wednesday, when the Fed's minutes showed that FOMC committee members are much more "Hawkish". Let me first explain what do these words "Hawkish" and "Dovish" mean.

Hawkish: Favouring increasing interest rates; inclined towards increasing interest rates.
Dovish:  Disfavouring increasing interest rates; inclined towards not increasing interest rates.

Let's analyze Fed's mandate. Federal Reserves has a dual mandate:

1- Control inflation:
2- Maintain unemployment levels

Fed controls inflation by increasing or decreasing interest rates. Inflation is caused by free movement of money in the system. If there is more money, it will cause inflation. If the money supply is reduced, it will reduce inflation or even cause deflation.

Typically, when economy is growing it causes inflation because people have more money and they tend to buy more. This increase in buying power results in higher prices of stocks, real estate, commodities and other investment instruments, which in turn forces people on the sidelines to join the buying frenzy.

Under such circumstances, Federal Reserves uses interest rates to reduce inflation. They increase the interest rate to give an incentive for people and institution to save versus invest. Since investors can earn higher interest without taking any risk, they prefer to save. Saving money in banks results in lower monetary supply, resulting in lower number of buyers of stocks, commodities and real estate. This helps in cooling down inflation.

Lower demand forces companies to adjust their production. For example, if there is low demand of housing then construction companies will lay-off people. Housing industry will be followed by other industries, which will result in higher number of layoffs and an increase in the unemployment rate.

As a result of increased unemployment level fewer people will be able to buy, resulting in lower inflation. As inflation goes down and unemployment goes up, Federal Reserves again uses its interest rate tool to adjust these two areas. However, this time they reduce the interest rate. By reducing the interest rate, they reduce the incentive related to savings. This reduced incentive forces individuals and banks to again start investing in the investment areas, which again increases the monetary supply. And the cycle starts again.

This cycle allows FED to maintain the economy in the perfect state of equilibrium. However, right now Federal Reserves has a very strange dilemma at its hands. Interest rate maneuvering & QE has not improved overall unemployment situation. And now, interest rates have started to go up in anticipation of inflation caused by QE induced price increases, even without Federal Reserves increasing its rates. In other words, market is telling Federal Reserves that if you won't increase the rate, we will do so without you.

So Fed has two options now:

1- Keep the rates low, with the hope that people will keep on investing and inflation will not start rising. This option is bad because it will result in increased inflation, which will result in higher rates. Higher rates will choke-off ability of investors to invest in business activities. Thus, choking off economic recovery.

2- Increase the interest rate to kill inflation expectations. This reduction in inflation expectation might result in a decline in interest rate, in the next few years but it will bring back deflation fears. Higher rates from Federal Reserves, will reduce investment incentive at the bank-level. Again choking-off the economic recovery.

Under both scenarios, Federal Reserves' is playing a losing games. Logically, Fed will go with option 2. This will allow them to reduce inflation expectations, keep investments going a bit longer. Reduction in expectation will result in lower interest rates in the interim. However, in the long-run we will experience another bout of Deflation, and possibly another stock market crash.

This analysis flows well with the current bond market's technical picture and the housing industry's forecast. Both of these trends combined suggest that a very good time to buy houses/real estate is coming in the near future. 

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