Tuesday, August 10, 2010

Federal Reserve: More Money Printing To Prevent Deflation

On July 2, 2010 I wrote the following:

Interest Rates

So where are interest rates heading? Your guess is as good as mine, but here are my thoughts.

I believe interest rates are headed down and may stat there - unless we get an oil shock. If you have been reading my blog you will have noticed that I’ve tilted more toward the Deflation camp and have been warning that interest rates may fall further. In fact, that is what has happened. Could they fall even further? It is possible. Just look at Japan. For this reason, I don’t expect the Federal Reserve to raise interest rates until 2011 (or longer), meaning more pain for investors looking for income. Income investors are paying the price for the bailouts. Having said all that, I cannot rule out an Oil price shock. War and more fallout from oil leaks could put a crimp on supply or expected supply which could lead to high oil prices (right now prices are falling due to unexpected lower demand globally) and those higher oil prices could have inflationary effects on the economy (please note that this is not true inflation).

Longer term I believe there is a high probability the Federal Reserve will resort to another round of Quantative Easing or money printing. While many believe this will lead to inflation or a hyper-inflation (hence the Gold-bugs) I am not yet convinced. If all the printing simply ends up back on bank balance sheets and thus not in the economy it may have no affect (other than to take bad assets off the balance sheets of Too Big Too Fail banks). For money printing to work the money must circulate in the economy (referred to as the Multiplier), as of now it is not. While this does present an opportunity to be in high-grade intermediate bonds, I’m not convinced there are not risks there as well, but you can be assured I will continue my quest for appropriately priced income-risk assets (note, “income-risk assets” is a term I just made up).

Today the Fed announced another round of Quantative Easing, though with the goal of maintaing the balance sheet not expanding it. Essentially the interest and and principal payments coming in from the Mortgage Back Securities was retiring the securities, this money will be reinvested into longer term treasuries instead of allowing to disappear.

Scott Dauenhauer CFP, MSFP, AIF