The weak March government nonfarm payroll report almost certainly means the Federal Reserve will continue its monthly strategy of buying billions of dollars worth of United States Treasuries and mortgage-backed securities in the near future. That strategy promises to expand the Fed’s balance sheet even more than it has in recent years. But the central bank knows there are limits to what its policies can do.
The Fed’s assets stood at $3.2 trillion at the end of March, up sharply from $900 billion in the middle of 2007, or before the last recession hit. That adds up to a 25% average annual growth rate. If that rate were to continue at the same pace for another five years, the Fed’s balance sheet would be an even more sizable $10 trillion. The central bank doesn’t want to go down the road it is headed that long, though, given its heavy-duty monetary policy measures arose from what was perceived as an emergency situation.
For now, the bond-buying promises to continue, and push the Fed’s balance sheet toward $4 trillion. One astute observer, the late Michael Farrell, co-founder of Annaly Capital Management (NLY), predicted early on in the financial crisis that the Federal Reserve would reach that level.
With any luck, the central bank will before too long be able to wind down the bond purchases and adopt a lower profile. One positive is that the content of the Fed’s assets is now much more plain-vanilla than it was during the dark days of the recession. Most of the stress-induced lending facilities and the unusual assets the Fed would never consider holding unless a dire situation was unfolding are gone. What’s mainly different now about the Fed’s balance sheet versus its pre-financial crisis days is that it has more than double ($1.8 trillion) the amount of U.S. Treasury securities that it had and $1 trillion of mortgage-backed securities that it did not have.
Proponents of the Fed’s asset-buying spree note that it has provided clear benefits, especially with respect to the once-dormant housing market. After lowering its short-term interest-rate target to zero, the Fed’s bond buying (also known as quantitative easing) helped to push mortgage rates to record lows. That is providing home-buyers with an opportunity to lock in extraordinarily low rates on 15- and 30-year loans. The housing market revival is a clear benefit to homebuilders, such as Lennar (LEN) and NVR (NVR). The low-rate environment has also helped to boost auto sales. Having those important sectors of the economy improving speaks well for the Fed’s hard work.
The Federal Reserve has the leeway to engage in asset purchases since inflation is contained, notably with respect to wages, and the Fed is inclined to be more aggressive as fiscal policy, stemming from Congress and the White House, becomes less supportive. The United States’ position as the world’s leading economy and the dollar’s status as the world’s reserve currency also help the Fed do what it feels needs to be done.
Critics claim the asset-buying program devalues the dollar, and lays the groundwork for inflation. That is one reason the price of gold is much higher than it was before the financial crisis. But there is no serious challenge to the dollar’s global supremacy these days, given the uncertainty surrounding the euro, its closest competitor.
All told, we applaud the positives of the Fed’s extra-aggressive monetary policy. But we also note that it is creating extreme environments in segments of the economy. Those include the bond market, the pension and retirement industry, and possibly agricultural real estate. The potential for headaches down the road in those areas, prior to the Fed achieving its targeted 6.5% unemployment rate, might cause the central bank to consider winding down its asset-buying plan earlier than it otherwise might have. Near-zero interest rates provide plenty of stimulus on their own.
At the time of this article, the author did not have positions in any of the companies mentioned.