Issue 30 • JUNE 24, 2009

The Fed Held Hostage?

Last week, the Obama administration introduced its plan to overhaul regulation of the financial sector, including some good ideas for holding Wall Street more accountable for the mess they helped create, in the hopes of avoiding future meltdowns.

The Fed would get some new power — to monitor financial giants that may pose “systemic” risks to the system — and we applaud some aspects of this new plan. But one provision in the President’s 85-page reform proposal immediately set off alarm bells for me ... although the media didn’t seem to take much notice.

Here’s the alarming part (the emphasis is mine) ...

“In order to improve accountability in the use of other crisis tools, we also propose that the Federal Reserve Board receive prior written approval from the Secretary of the Treasury for emergency lending under its ’unusual and exigent circumstances’ authority” and will “propose legislation to amend Section 13(3) of the Federal Reserve Act.”¹

Granted, an overhaul of current regulatory oversight is long overdue, considering the fact that multiple government overseers were totally asleep at the switch during the run-up to the biggest financial crisis of our lifetimes.

But, in this case, the regulatory pendulum is in danger of swinging too far in the wrong direction.

What this proposal means, in plain English, is that the Federal Reserve is at risk of becoming a political prisoner ... to the U.S. Treasury department. Authority for certain Fed policy decisions — such as those made during this crisis — would now be dependent on prior “written approval” from politicians.

What’s worse, the Fed won’t even be answering to elected officials, mind you ... but to an unelected political appointee ... the Treasury Secretary.

Monetary policy, in other words, could be held hostage to the whims of any future administration that calls the shots ... putting even more power in the hands of a few politicians.

Some may consider this just a small step toward greater oversight of the Fed ... but it can also be considered a giant leap toward giving in to political pressure from the White House.

Talk about the danger of unintended consequences ... this would potentially create many more problems than it might solve.

Whether the Fed is truly independent today is perhaps debatable already ... but there is little doubt that much closer ties have existed for years between Wall Street and politically appointed Treasury officials (Hank Paulson, Bob Rubin, etc).

The so-called independence of the Federal Reserve — at least compared to other central banks — gives the U.S. enormous credibility in the eyes of foreign investors.

It is one reason why so many sovereign governments have, for years, preferred to keep such a large portion of their cash reserves denominated in U.S. dollar assets, such as Treasury and government-agency bonds.

The Fed’s mandate is to promote low inflation and economic growth, but if forced to choose, you can assume that most politicians will pick more “growth” over “fighting inflation” almost every time.

It’s just too easy to err on the side of lower interest rates and greater jobs growth. This is certainly a much easier decision than making the tough choice to hike rates, which may keep inflation low, but only at the expense of more unemployed voters!

Foreign investors could easily lose confidence over the prospect of a more politically dependent Federal Reserve. The temptation for the Fed to simply inflate away our growing government debts would become a much greater risk for bond holders.

After all, from their point of view, our debts are their assets ... the value of which could be in jeopardy with politicians — rather than central bankers — calling the shots.

In another troubling sign for investors, this financial regulation plan also extends creeping government control over yet another sector of our “free market” economy.

You can add the banking and financial sectors to a growing list of industries including: agriculture, auto, housing and health care ... and you’ll find that “nearly half the nation’s GDP” is now subject to Washington’s growing “industrial policy” influence ... so much for free-market capitalism.²

Speaking of the Fed ... the Federal Open Market Committee wraps up a two-day policy meeting today, and what they say ... or don’t say ... could help determine if the bear market rally since March continues or comes to a full stop.

The Fed is not expected to change its interest rate policy — from a Fed funds target range of 0% to 0.25% today — but market watchers will be closely dissecting what the Fed has to say about the economy.

We note that some interesting things happened on the road to a “green-shoot”-inspired recovery in recent months. Perhaps it was too much anticipation of economic recovery ... or maybe too big a supply of new Treasury bonds issued to finance all the government bailouts ... but low and behold, long-term interest rates have been rising.

Yields on the benchmark 10-year Treasury bond surged to 3.8% in early June, up from just 2.1% in mid-January.³ That’s a near doubling in yield folks! So, while the Fed continues to hold down short rates, its ability to effectively drive down longer-term interest rates is in question.

This matters because, among other things, 30-year fixed rate mortgages are often tied to long-term Treasury rates. Indeed, the interest rate on new mortgage loans jumped from record lows of less than 4% recently to more than 5%, before pulling back last week to about 4.5%.⁴

While still relatively low by historic standards at 4.5%, the Fed has sought to push mortgage rates even lower in hopes of relieving the stress on millions of underwater American homeowners. To avoid becoming renters again, many homeowners may yet need to refinance their mortgages to still lower fixed rates.

But, in fact, mortgage rates today are even HIGHER than before the Fed announced in March that it would expand purchases of mortgage-backed securities in hopes of driving down interest rates.

Not surprisingly, mortgage refinancing activity fell 23% for the latest week — and has plunged over -70% from the peak in April — due to rising home mortgage rates.⁵

So, all eyes are on Bernanke & Co. today ... to see if the Fed has any more tricks up its sleeve. You can bet we’ll be watching and listening very closely. Stay tuned…

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ Bank of America Merrill Lynch: Slippery Slope, 6/17/09
² Cumberland Advisors Market Commentary, 6/18/09
³ Bloomberg: Bernanke Conundrum Threatens Housing on Mortgage Rate, 6/8/08
⁴ Bank of America Merrill Lynch Market Economist, 6/19/09
⁵ Ibid.