Parsing the Fed

Understanding the Federal Reserve is not easy given their convoluted, jargon-laden use of the English language. They have, however, improved since Alan Greenspan's tenure during which he took pride in confusing Congressional panels. It never seemed to bother him or Congress that he was mandated by law to explain the nation's monetary policy and, yet, publicly took pride in his ability to befuddle members of Congress.

Anyways...here is a link to the NPR "Planet Money" site (one of the very best resources for those interested in entertaining ways to learn economics) that parses the most recent Fed statement explaining the $600 billion quantitative easing policy. It uses a tool created by Slate's Jeremy Singer-Vine called "Plain English."

Quantitative Easing - Part II

There are two subtle dangers to quantitative easing (QE) that go beyond the massive build-up in bank excess reserves which could lead to an explosion in the nation's money supply and virulent inflation down the road. Before I get to them, let me say that a lot of people feel like we're watching Charlie Brown getting ready to kick the football as Lucy is placing the football in place. We've been down this road before in a different guise. Ten years ago we were assured by a prior administration that, by today, we would have balanced budgets. Well, where are they? What? We can't cut spending because of unemployment pushing 10%? The deficit is $1.3 trillion.

Today we are told that, when it comes time to reverse the QE to sell longer-term Treasuries to counter inflation, the Federal Reserve will be up to the task. Please, Charlie. Don't try to kick the ball!.

Danger I
Suppose QE is successful. Suppose the unemployment rate drops as inflation rises, but inflation is nipped in the bud as the Fed successfully reverses its policy. How could this possibly be a danger? Let's think back. Former Fed Chairman, called the "maestro" in the latter part of his tenure, was seen as the best Fed Chairman to ever hold the position. He was adept at manipulating the fed funds target rate every time the economy needed a boost or was viewed as too strong. Eventually traders came to expect a bailout by the so-called "Greenspan put." In other words, it led to excessive risk taking. We are still trying to dig out from the consequences.
Success this time will make it easier to use next time. This leads to ongoing manipulation of the economy until risk is no longer correctly priced. This is a dangerous situation.

Danger II
We are slowly digging deeper and deeper into a "do as I say, not as I do" situation. Consider Treasury Secretary Geithner's remarks:

“We will never use our currency as a tool to gain competitive advantage,” Geithner told
reporters today after a meeting of finance ministers from the Asia-Pacific Economic
Cooperation group in Kyoto, Japan.

Huh? Is there anyone who isn't pointing to the beneficial impact on the U.S. Trade Deficit from the falling dollar. On the previous quantitative easing post, Shawn Watson commented about arrogance. Are our officials not aware of how arrogant we look when we say one thing, do another, and then tell other countries how to manage their currencies?

Kiplinger's "Best Simple Portfolio"

Kiplinger's "The Best List" has a number of interesting entries this month, among which is their "Best Simple Portfolio"." In line with the theme of this site, it is comprised of low cost funds:

33% VTSMX Vanguard Total Stock Market
33% VGTSX Vanguard Total International Stock Index
33% VBMFX Vanguard Total Bond Market

This portfolio, as they point out, beats most investors. In fact, over some longer periods, similar types of portfolios, after fees, have been shown to beat 90% of active professional investors who tout their stock-picking and market-timing abilities.

Kiplinger's reports that, over the past 10 years, it has achieved an annualized return of 3%. Year-to-date through 11/4, it is up 11.14%.

I agree with Kiplinger but would prefer to use exchange traded funds and flesh out the portfolio a bit with a few extra funds. Also, the portfolio has to be adjusted for risk tolerance specific to particular investors. In any even,t investors can easily adapt the "simple portfolio" to use as a benchmark to assess how well they or their advisor is performing.

What Is Quantitative Easing?

Yesterday the Federal Reserve, accompanied by considerable hoopla, announced a $600 billion "quantitative easing" (QE)program. This is actually QEII. After QEI, the stock market moved higher; so understandably some are happy. The job market? Not so much.

To understand QE, it is helpful to review normal Federal Reserve policy. Typically the Fed targets the federal funds rate. This is the rate at which banks lend each other reserves. Banks are required by the Fed to hold reserves versus deposits. The federal funds rate affects other short-term rates. Longer term rates are typically influenced by inflation expectations - not the Fed.

As it has turned out in the current business cycle, the targeting of the fed funds rate is no longer an option for improving the economy because the Fed has pushed it to practically zero, with zero results. In other words, the Fed lowered the rate to practically zero; and we still have unemployment close to 10% with the possibility of further job market deterioration.

QE is a different policy from targeting the fed funds rate. Instead of targeting a short-term interest rate, QE commits a certain amount of money to buy longer maturity bonds. It will impact longer term interest rates. Yesterday the Fed announced a $600 billion QE program.

Here's the thing to get: the Fed creates money out of thin air. Think about this - if you want to buy my house, you have to get the money from somewhere. You have to get it from your savings or borrow it from somewhere. Not so the Fed. It just writes a check. What backs the check? Nothing. It is what is called "fiat money" - money by declaration. Money is literally created out of thin air.

Yesterday I posted a video where people were interviewed asking if Obama was a Keynesian. The responses were pathetic. Some thought the question was about if he was from Kenya. Along the same lines, if you asked people if gold backs the nation's money supply, most would say yes. The American people have no idea how Federal Reserve policy works. This would require an understanding of our basic economic system - something our leaders in education haven't deemed important.

Anyways, when the Fed buys bonds, the check is deposited and, thereby, the amount of money in the economy is increased. Banks can lend the excess reserves created by this transaction, and the amount of money in the economy would go up even more. This is what the Fed is hoping for but hasn't occurred yet.

This process is called "monetizing the debt"." And there is a lot of debt out there. It is the equivalent of running the printing presses to print money.

Why is the Fed buying bonds? After all, they could put money into the economy by buying anything - used cars, for example. They are buying bonds because it is a way to control longer-term interest rates - like the rates on mortgages, for example. They've come to the end of the line on controlling short-term interest rates; now they are after longer-term rates. In other words, they are now controlling the price of short-term money and long-term money.

QE is just another step on Hayek's "Road to Serfdom".

Is Obama a Keynesian?

I watched this video closely two times to ensure that none of my ex students were in it. If they had been, I was going to get some change of grade forms and submit "F"s. Thinking about yesterday's elections - don't complain people - we get exactly what we deserve! I'm not sure if I've ever seen a better piece on why the school system needs reform.

The Rule of 72

Last night's class was about inflation; and we talked a bit about what the CPI measures, how it is measured, and some of its shortcomings. During the class, I brought up the "rule of 72" mainly to show how long it takes for prices to double under given rates of inflation.

The rule of 72 is a good way to look smart, and one of the objectives in the work world is to convince people (especially your bosses) you're smart.

For example, if you tell me an investment will earn 4%/year, then I can tell you right away, off the top of my head, that it will double in 18 years. Pretty smart, huh?

To provide a practical application of the rule, I decided to spend a couple of minutes showing the results of saving at a young age.

The Rule
The rule is simple: 72 divided by a growth rate gives an answer on how long it will take for a magnitude to double. For example, if something is growing 8%/year, compounded, then the rule says 72 divided by 8 = 9 years. 9 years is the time it will take to double.

For homework, figure out how long it will take for a magnitude to double if it grows 4%/year.

The Lesson
Next, by a show of hands, I asked how many students were 20 years old; and most of the hands went up. That's what we worked with. I assumed an initial investment of $1,000 and an 8% average annualized compound return. By the rule of 72, that $1,000 will be $2,000 by the time the 20-year-old turns 29 years old.

We get the following:

29th birthday $2,000
38th birthday $4,000
47th birthday $8,000
56th birthday $16,000
65th birthday $32,000

If you think about this a little bit, you'll be able to understand why the dollar today is worth approximately one-fifth of what it was worth when I was in school (3 Musketeers bar cost $.25 versus $1.25 today). You'll understand Henny Youngman saying "the country's getting stronger - it used to take 2 adults to carry $20 worth of groceries, now a 5-year-old can do it." These, of course, are different ways of expressing inflation.

I let the class in on another piece of news. Subject to the workings of the Darwin awards, most of them would wake up one morning surrounded by friends and family with a birthday cake to celebrate their 65th birthday. This is not easy to grasp for a 20-year-old. It wasn't easy for me when I was 20.

The point is a basic one of personal finance: save when you're young and you don't have to save as much.

The corollary is: saving when you are young gives you choices when you are older. This is where a Walmart greeter as a guest speaker would be useful.

Additional Resource Interesting YouTube for those interested in critical thinking and learning more about the rule of 72.

Some Year-To-Date ETF Returns

Here are some year-to-date returns on indexed exchange traded funds from Morningstar :

Vanguard Total Stock Market VTI +9.14%
Vanguard Europe Pacific VEA +5.47%
Vanguard Emerging Markets VWO +13.96%
Vanguard Total Bond BND +8.28%
Vanguard REIT Index VNQ +25.34%
SPDR Gold Shares GLD +21.59%
GSCI Commodity Index GSG -2.28%

Returns are based on NAV. To find performance numbers, go to the Morningstar site ; enter ticker symbol :

CLICK TO ENLARGE Click "performance" and scroll down.



CLICK TO ENLARGE

The funds' returns vary widely and may indicate a need to rebalance from, say, the REIT fund VNQ to the commodity index fund GSG, depending on the rebalancing band used.

Disclosure: the data here is for informational purposes only and is not intended as a recommendation. I hold some of the funds mentioned.