William Dudley, president of the Federal Reserve Bank of New York, argued on Monday that one explanation for the sluggish economic recovery is that the Fed should have acted more quickly and boldly in easing monetary policy as the severity of the recession became apparent. His comments served to illustrate the growing divergence of opinion between the “hawks” and the “doves” at the Fed’s policy body, the FOMC.
In remarks delivered to the annual meeting of the National Association for Business Economics in Lower Manhattan, Dudley presented the dovish case for more central bank action by recounting the degree to which economic forecasters overestimated the strength of the recovery, and then noting several reasons for the underperformance.
Predominant among these factors was his belief that the Fed relied for too long on traditional incremental interest rate policy before plunging into more exceptional moves like buying and holding government bonds. Recessions triggered by financial crises such as we endured in 2008 are generally more severe and extended than more typical business cycle downturns. Once the Fed recognized the pattern, the thinking goes, it should have rapidly expanded its balance sheet and flooded the markets with cash.
It should be noted that not all members of the Federal Reserve System agree with this assessment; the “hawks” on the FOMC have argued that enough has already been done and that inflation is certain to greet the Fed’s attempt to unwind its aggressive stance. These critics have not carried the day, as concern over long-term unemployment today has trumped the threat of price risk tomorrow (or in 2015).
Dudley clearly recognizes risks in the accommodative strategy. The real responsibility for promoting a recovery rests with Congress and the White House, who have so far been unwilling to move on productive tax reform and debt reduction measures. So, the Fed is left to play Sisyphus, pushing the stone uphill and inventing another flavor of Quantitative Easing each time it rolls back down.
For investors, this policy has important implications. Stockholders love it, since the key element is to boost asset prices and impart a feeling of increased wealth that might lead to additional consumption spending.
For more conservative investors, particularly bondholders, the risks are growing daily. One obvious byproduct of the Fed’s accommodation is the impossibly low interest rates on offer to savers and particularly to retirees. Many are faced with the conundrum of spending principal or accepting additional risk to boost expected returns. Ratcheting up risk, particularly in longer-dated bonds and bond funds, increases the potential for capital losses once interest rates actually start to move higher.
Asked about this risk to older, more conservative investors, Dudley obliquely replied that each investor bears the responsibility of monitoring his or her own portfolio on an ongoing basis. Your problem, not ours.
Policy actions necessarily involve tradeoffs; in this case promoting jobs over rewarding savers. Bond investors should be prepared to take swift action once the hawks prevail.
Christopher A. Hopkins CFA, is a vice president at Barnett & Co.