Thursday, January 31, 2013

Why do they pay these guys so much?


Okay, I don’t know how much this guy gets paid to do his job but I’m sure it’s more than I get paid.  I can tell by his tie.  Anyway, he thinks that the Fed is being counterproductive.  I think he meant ineffective, but counterproductive probably makes a better headline.  Whether the Fed is being ineffective, we have to understand where we would be if the Fed had not taken the actions that it has.

So, let’s think about this for a minute.  First, the Fed has dropped short-term rates to as low as they can go.  The theory is that other rates will follow the short-term rates lower; businesses will borrow to increase investment spending, followed by increasing hiring and decreasing unemployment, which is then followed by increasing consumption spending.  It didn’t really work out that way.  While longer term rates did fall, it wasn’t enough to really entice businesses to invest because they didn’t see an increase in demand coming.  This could be explained, at least in part, by falling home prices which resulted in a large decrease in wealth among consumers.

Lower mortgage rates would normally lead to increased demand for real estate, but the Fed apparently believed that the rates weren’t low enough to drive enough demand for housing to drive housing prices higher, so they decided to take a direct approach and purchase MBSs to push mortgage rates lower.  But, the action is limited again by market factors, which includes the rates on long bonds, which effectively put a floor on how low mortgage rates can fall.  So, the Fed decided to purchase long bonds to drop the yields on those, which would allow mortgage rates to fall a little more.  It certainly seems as if that has happened.  Home prices, at least on average, are rising.

But the problem with mortgage rates is that, if the Fed actually does increase home buying by pushing rates down, the increase in demand for new mortgages will push rates back up, so the effect on real estate prices is probably short-lived.

In the meantime, the Fed’s actions are pushing investment money into higher risk assets because the Fed has effectively crowded investors out of low risk investments.  This is good for the stock market, as well as lousy analysts because when the stock market rallies, it’s easy to look like a genius.  But I digress.

There actually is another reason for the flight to high risk investments - the dividend yields on a lot of stocks, which are higher than bank interest and taxable at a lower rate than bank interest.  And why are dividend yields so high?  Because businesses aren’t investing in capital, like they normally would be because they don’t expect the demand to be there.

So, all that’s happening right now is there is a lot of extra money in the financial markets, and that’s where it will stay until everyone realizes that even stocks aren’t offering a reasonable return.  But what happens then?  The big question is what people will do with their money when every investment is a bad investment.

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