The Fed's Newest Service: Portfolio Insurance

Every generation believes that they know more than the previous generation. Then, as they get older, they slowly start to realize that their elders aren’t as dumb as they thought. It's normal.

What's different today is that we seem to think, or at least many people do, that not only are we wiser today than everyone who has come before us but that humankind has been doing everything wrong for the past 5,000 years or so of civilization. Whether it's morally wrong to eat meat, or how many genders there are, or who can marry who, or whatever, it seems that we've been misguided since the beginning of time.

This attitude also manifests itself in the economic sphere. Based on the Federal Reserve’s recent actions, they appear to believe that everything we knew or thought we knew about economic cycles and bull and bear markets has been all wrong. Thousands of years of boom and bust cycles could have been eliminated, apparently, if only the proper monetary policy fixes had been applied.

Quite clearly, the Fed’s new mandate is that if economic growth starts to sputter, or the stock market moves beyond a correction, or some international crisis – Brexit, Megxit, Iran, North Korea, trade wars, you name it – threatens to upset the applecart, it will immediately turn its monetary policy tools into high gear.

Before now, economic growth and stock prices were pretty much allowed to take their own course, with some attempts to smooth out the worst excesses. It was considered to be both normal and healthy for markets and economies to go up and down periodically, as long as the general trend was upward. Now, however, that appears to be not only quaint, old-fashioned thinking but just plain wrong. There is no reason, the thinking goes, for us to suffer any economic pain as long as we have the policy tools to avoid it.

The Fed now operates under the 2% rule. If economic growth looks to be heading below 2% annually, then the Fed will step in and add funds or buy bonds or lower interest rates to get it back up to that target. It’s not going to wait until we fall into recession. It calls that new policy “insurance.” Similarly, if inflation fails to rise to the Fed’s 2% target rate, it will similarly ease monetary policy to try to get it up there.

While the Fed over the past 10 years or so since the financial crisis has failed to achieve that desired 2% inflation rate, inflation at least has stayed below that figure, which to most people is more important. The average person wants little or no inflation even though the experts think it's preferable for inflation to be at or above that level.

Does this mean that, if the Fed is successful, there will be no more recessions and no more bear markets? Apparently so. It's not clear at what point the Fed would stand down and allow nature to take its course, as it were. However, the last several years have shown that the Fed has no inclination to allow that to happen. Rather, it will not tolerate the slightest weakening of economic growth or a market correction of more than 10%.

This appears to be the Fed's long-term, indeed, permanent intention, not just emergency measures in the wake of the financial crisis.

While this all sounds nice and comforting, is it real? Can we, in fact, put an end to recessions and investment losses through monetary policy, as if we were fixing the slot machines at Mohegan Sun to guarantee a win every time? Have the laws of economics and finance been wrong all this time?

Think of all the financial depressions and recessions and panics and bear markets that could have been avoided if only our ancestors had been as smart as us. Is this what they mean by a “planned economy”?

So what does this mean for investors?

If I'm right, and the Fed is going to be proactive to ensure we always have 2% inflation and 2% economic growth, that would imply that long-term interest rates would also be around that same level. Does that mean, then, that there is no point to investing in long-term bonds with such a flimsy return? Or should we just be satisfied with that kind of return on bonds?

The alternative, of course, is that investors invest only in risk assets such as stocks or even riskier investments such as high-yield bonds and the like. That has been the case pretty much since the end of the financial crisis when the Fed went full-bore into manipulating the economy and the markets. So far, that’s worked out pretty well; we’d have to agree.

So go ahead and take on more risk. The Fed has your back.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.

4 thoughts on “The Fed's Newest Service: Portfolio Insurance

  1. It is bad for the psyche. We used to be able to use some self control in our spending, but not anymore. We don't mind taking on debt that could literally extend beyond our lifetime, and there is no shortage of willing financiers. The effect is that leveraged the way we are, even a slight recession would become a catastrophe, and people are getting very used to living in excesses. There is a dead end somewhere up ahead. Fed or no Fed there always will be.

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