Fed Promotes Fairy Tale
The Federal Reserve (Fed) needs to buy time while maintaining credibility that it has its eye on inflation. The sound thing to do would be to stop its inflationary policies. Instead, the Fed is extending its mortgage-backed securities (MBS) program – this is not surprising to us as we expect the Fed to subsidize the markets for a considerable time.
That’s because, in our assessment, when the Fed buys MBS or other securities, the Fed foremost replaces rather than encourages private sector activity. Specifically, when the Fed buys securities on a large scale, these securities are now intentionally overpriced; any rational investor may be discouraged from buying the same securities. The reason the market goes along – for now – is because buyers know they can "always" sell to the Fed; well, this cushion will go away should the confidence in the Fed erode as the Fed is ultimately only a small fish in a very large pond. In the meantime, the decline in the U.S. dollar may accelerate if investors feel they are not properly compensated for the risks they are taking investing in U.S. securities.
The Fed statement released today reads "substantial resource slack [will] likely continue to dampen cost pressures;" however, in the FOMC Minutes released earlier this month, some Fed officials correctly noted that there is no firm empirical evidence supporting the relationship between the resource slack (also called output gap) and inflation. Instead, inflationary expectations are a key driver of inflation, i.e. if businesses believe inflation is in the pipeline, they will try to push prices higher. However, it is far more convenient to pound the table on the output gap, promoting what we have for some time called a fairy tale.
Axel
Axel Merk
Author of Sustainable Wealth – available to pre-order now.
President and Chief Investment Officer, Merk Investments
