decision to make
an official goal incited a market rally on Tuesday, though the long-term implications of its monetary policy are more complicated.
The Fed slashed its key interest-rate target from 1% to a range of 0% to 0.25%, while vowing to do whatever it takes to stabilize the financial system. The Fed is evaluating a broad array of debt to purchase, from
to long-term Treasury bonds, as well as the extension of loans to households and small businesses. The Fed promised to "employ all available tools" to get the markets in order and foster economic growth, and it's exploring other methods that it did not detail.
Following the Fed's action and muscular
Dow Jones Industrial Average
soared nearly 360 points to close at 8924.14. The rate cut surpassed expectations of the market, which had been betting on a more modest cut to 0.5%.
The agency's moves imply that troubled debt will be extracted from companies' balance sheets, rendering them as more attractive investments, that prices for such debt will finally be discovered and that credit conditions will improve for consumers, businesses and banks alike. The government may have little choice but to step directly into the market, as it has, if it intends to speed up a turnaround and avoid a protracted recession. Still, it's important for investors to consider the short- and long-term consequences when structuring their portfolios around the fluid government strategy.
First and foremost, while the market responded with an impressive boost to stock prices, the bear-market rally may be short-lived: Stocks eased again Wednesday as enthusiasm faded. Furthermore, while the cut seemed dramatic, in practice interbank lending rates were already within the Fed's new range. Ladenburg Thalmann analyst Richard Bove characterizes the move by saying "the Fed does not set rates but rather it chases the free markets."
But Bove also notes that, over the longer term, the notion of free money, and the Fed's intention to print more of it to buy questionable assets, has dire consequences for the value of the dollar. Indeed, the dollar has fallen sharply against other major currencies since the Fed's decision. That, in turn, drives up prices for dollar-based goods, including oil, food and anything else purchased at the local grocery store.
Of course, in an environment where the Fed is fighting deflation, which can have much worse effects than moderate inflation, its concerns about the latter are minimal. But a weaker dollar has other effects as well. Dollar-based investments become less attractive, foreign governments are encouraged to devalue their own currencies, and rates for private debt are driven up, while Treasury yields sink to new lows.
There is also a minimal danger that, on top of unintended negative consequences, the Fed's moves may not produce the results it seeks. Japan's economic crisis of the 1990s, in which it cut rates to 0% for a decade but was unable to fight deflation, continually resurfaces as an example of such monetary policy gone haywire. But, for now, there seems to be little concern about a similar situation occurring in the U.S.
Vincent Catalano, chief investment strategist for Blue Marble Research, says the U.S. consumer, while undoubtedly battered today, will never be weak enough to allow prices to fall so sharply for such an extended period of time. The thirst for goods has been temporarily cloaked, Catalano asserts, but demand will return in full force once the right incentives are in place.
Old habits are hard to shake," Catalano writes on his blog.
As the dust begins to settle in 2008, many market observers are predicting a turnaround in the not-too-distant future. Yields on junk bonds, and even certain corporate bonds, have risen to all-time highs for the few who are willing to finance riskier debt. Stock prices for many blue-chip firms are far below book value. Nearly all the Dow components, including industrials like
, energy giants such as
, and household names including
Johnson & Johnson
, are down for the year.
Some predict that, in light of the heady reward potential, investors will once again warm to equities and private debt. When that time comes, the current trends are certainly setting up a massive opportunity for those who manage to jump in at the right moment to reweight holdings just before yields and prices reverse. But, of course, bottom-seekers bet wrong much of the time, and there's no telling what might happen in the intervening months.
For now, investors are willing to settle for paltry returns on safe government debt, much more of which will be issued in the coming year to fund Uncle Sam's costly plans to shore up the economy.
"You never want to stand in front of the Fed. They're going to be successful in what they're doing," says Paul Mendelsohn, chief investment officer with Windham Financial Markets. "It's not going to happen overnight, and it's going to be a little more painful than people think it's going to be, but it's going to happen. The question is what's going to happen after that."