C´MON BEN ! / BARRON´S COVER ( HIGHLY RECOMMENDED READING )

Monday, October 19, 2009

BARRON'S COVER

C'mon, Ben!

By ANDREW BARY

We make our case for the Fed to increase short-term interest rates to a more normal 2% -- or risk fostering another financial bubble.

IT'S TIME FOR THE FEDERAL RESERVE TO STOP talking about an "exit strategy" and to start implementing one.

There's no need for short-term rates to remain near zero now that the economy is recovering. The call to action is clear: Gold, oil and other commodities are rising, the dollar is falling and the stock market is surging. The move in the Dow Jones industrial average above 10,000 last week underscores the renewed health of the markets. Super-low short rates are fueling financial speculation, angering our economic partners and foreign creditors, and potentially stoking inflation.

The Fed doesn't seem to be distinguishing between normal accommodative monetary policy and crisis accommodative policy. There's a huge difference.

With the crisis clearly past, the Fed ought to boost short-term rates to a more normal 2% -- still low by historical standards -- to send a signal to the markets that the U.S. is serious about supporting its beleaguered currency and that the worst is over for the global economy. Years of low short rates helped create the housing bubble, and the Fed risks fostering another financial bubble with its current policies.

The Fed also ought to consider scaling back its massive bond purchases, which have totaled more than $1 trillion this year and have artificially depressed mortgage and Treasury interest rates. The Fed has virtually cornered the mortgage-backed market, buying about 75% of newly created government-backed securities this year, and that has forced the usual institutional buyers of mortgage securities into other markets, like corporate and municipal bonds. This has contributed to the sharp rally in munis and corporates.

Better to stop the Fed's bond-buying program sooner rather than later, and end artificially low, sub-5% mortgage rates. The more securities the Fed purchases, the greater the ultimate losses on its holdings when rates do rise. Banks also have bulked up on low-yielding Treasuries, buying over $200 billion in the past year.

It's also time for the Fed to consider the plight of the country's savers, who now are getting less than 1% yields on money market funds and who are being forced to take substantial interest-rate or credit risk if they want higher yields. "The Fed is punishing prudent people and rewarding profligate people," one veteran investor tells Barron's. Many unemployed and underemployed Americans may be deserving of some mortgage relief, but there also are millions of Americans -- most of them elderly -- who diligently saved and now have little income to show for a lifetime of effort.

WHILE SAVERS ARE SUFFERING AND MAIN STREET is hurting from still-tight bank lending policies, Wall Street is having one of its best years ever -- and rock-bottom short-term rates are a key reason. Goldman Sachs (GS) and JPMorgan (JPM) last week reported strong third-quarter profits, stemming in large part from trading activities. A flush Goldman is on course to pay $20 billion to its employees in 2009 -- or nearly $700,000 per person -- just a year after the wobbling firm got a critical government financial safety net. Goldman generated over 80% of its revenues from trading in the third quarter.

A quick move up to 2% -- or even 1% -- in the key Federal funds rate, now at just 0.15%, might shock global markets, where big investors have come to see the dollar, commodities and stocks as one-way bets. Major global equity indexes probably would fall, while commodities likely would fall and the dollar would rally.

Ultimately, higher short-term rates could help by suppressing incipient inflation while doing little to dampen a mending U.S. economy. Real GDP growth could top 3% in the second half of this year.

The Fed’s policy of near-zero short-term
interest rates is affecting a wide range of
markets. It is contributing to the sharp
drop in the dollar and the rally in gold. The
stock market has welcomed the lower
dollar, because it helps sales for big
exporters. But, ultimately, low rates could
stoke inflation and undermine the
confidence of overseas investors, who are
critical buyers of U.S. debt and equity.

Our view unquestionably is an outlier. With unemployment near 10%, few see a need for higher rates. And Fed chairman Ben Bernanke, while acknowledging that the Fed will need to pursue an "exit strategy" and tighten monetary policy, clearly wants to act later rather than sooner.

"My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period," he said recently. Financial markets expect the pace of Fed tightening to be very slow, with short-term rates not hitting 1% until October of 2010.

But some central-bank officials, such as St. Louis Fed President James Bullard, have been warning about inflation. And they have a point: Inflation is back, with prices rising 0.2% in September after increasing 0.4% in August. The CPI index could be up 2% in the next year, versus a 1.3% decline in the 12 months through September.

THE STOCK MARKET HAS BECOME A WEAK-DOLLAR constituency because a declining greenback boosts profits of multinational companies like Coca-Cola (KO) and Intel (INTC). Overall, companies in the S&P 500 get 30% of their revenues from abroad.

But maintaining the status quo could be short-sighted, since overseas investors are likely critical to the long-term health of the U.S. stock market. They've been burned by U.S. stocks in the past decade; the market's decline and a weaker dollar have meant 50% losses for European holders. If the U.S. wants to continue to attract overseas capital, it's going to need to support its currency.

Speculators, meanwhile, have been borrowing in dollars to buy a range of financial assets because of near-zero borrowing costs and the prospect of repaying those loans with a depreciated currency.

Low U.S. interest rates aren't the only problem for the dollar. Many foreign investors have been spooked by the record budget deficit and a perception that the Obama administration wants a lower dollar to boost exports and the economy.

The chances of the Fed moving away soon from a crisis-accommodative stance and near-zero short-term rates probably are small, because doves like Bernanke have the upper hand. There isn't apt to be any political pressure to raise rates.

That's a shame. The Fed and the administration are playing a dangerous financial and fiscal game because ours is a debtor nation that depends on the confidence of overseas creditors. If a resilient U.S. economy can't tolerate 1% or 2% short rates, this country really is in bad shape.

Copyright 2009 Dow Jones & Company, Inc.