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Federal Reserve Chairman Ben Bernanke. Will continued low interest rates lead to inflation? Some money managers don't think so.
The Federal Reserve's Open Market Committee announcement Wednesday wasn't a big surprise on the interest-rate front. The Fed has stated it intends to keep short-term rates low for the foreseeable future, in an effort to stimulate the economy and push investors into riskier assets, like stocks. A continued low-interest rate environment will also continue to bolster the housing market, where mortgage rates are at historic lows.
Fed Chairman Ben Bernanke and the rest of the FOMC annouced that they will keep rates low until unemployment falls to 6.5 percent. It will also continue to buy up mortgage-backed securities, at roughly the same rate it has been (so-called "Quantitive Easing," installment 3, or "QE3").
[UPDATE: I slightly misinterpreted what the Fed is doing on the bond-buying side. It's also worth noting that the Fed is now saying that it will keep interest rates low until unemployment hits a specified level. This is a policy departure from saying that rates will stay low until the economy improves. But anyway, bond-buying: the Fed is going to double what it's doing in the QE front and change "Operation Twist" into an extension of QE3. The older aspect of QE will still involve buying MBS. But the additions to QE3 will entail buying long-term U.S. Treasuries without selling short-term bonds. This is important as it means the Fed will be adding $85 billion per month to its balance sheet — under Operation Twist, it hadn't grown much, which was viewed as an way to "sterilize" against inflation. Former Dallas Fed President Bob McTeer has a good post about the FOMC decision at Forbes.]
However, low rates and ongoing types of expansionist monetary policy, like QE3 and Operation Twist, have compelled some observers to anticipate higher inflation in the future. One of them is Jeffrey Lacker, President of the Federal Reserve Bank of Richmond and a voting member of the FOMC who has consistently voted against keeping interest rates low, for fear that the policy is inevitably inflationary.
The worry is that all the easy money and easy credit in the economy will knock the supply-demand curve out of whack, creating the Econ 101 situation in which too much money chases too few goods, bidding up prices. We're currently getting a glimpse of what this looks like on a small scale in the Southern California housing market, where in some areas a combination of low interest rates on mortgages and a tight supply of homes for sale has inflated a price bubble.
But beyond isolated occurrences of inflation like that, how big a worry is the dreaded I-word?
I asked Dan Heckman, Senior Fixed Income Strategist at U.S. Bank Wealth Management Group. (U.S. Bancorp, the parent company, is the fifth largest commercial bank in the country, and although it's headquartered in Minnesota, it's familiar to L.A. residents for the U.S. Bank Tower downtown — the tallest building west of the Mississippi.)
"Inflation will not be a problem until we see a much tighter labor market," he said. "We have a tremendous amount of slack in that market now."
The current job market is anything but tight. Unemployment is at 7.7 percent nationally and at 10.1 percent in California. There are 12 million Americans out of work, and about 40 percent of them are classified as "long-term unemployed" by the Labor Department. Heckman noted that the U.S. lost more than five-million jobs during the financial crisis and that the labor participation rate is at its lowest level in decades.
Without a jobs boom to restore the U.S. to what economists call "full employment" — a 5-6 percent unemployment rate — there won't be enough people earning steady money to either spend it or start thinking about taking of major risks, like buying a home.
"Inflation doesn't become problem until you see wage inflation," Heckman stressed.
Investing in an environment where interest rates are low and inflation isn't raising the value of assets can be tricky. Heckman likes an investment class that some market observers have become more concerned about, in the wake of a series of bankruptcies in California cities (Stockton, San Bernardino, and Mammoth Lakes have all entered Chapter 9 this year).
"We think the municipal bond market is in much better shape than commonly thought," he said.
The attraction to munis?
"We like government debt that has tax advantages," he said.
Investing in municipal debt is a way to avoid taxes because on many of these bonds, the return is tax-exempt. They're also appealing now because it's highly likely, no matter what happens with the fiscal cliff negotiations, that taxes are going to be higher in 2013 than they were in 2012.
Yields on muni bonds can be higher than other asset classes, because there's additional risk associated with investing in municipalities rather than, say, simply buying ultra-safe U.S. Treasuries. Moody's recently announced that it was conducting a review of numerous California cities to discern if Stockton and San Bernardino are simply wrinkles in the multi-trillion dollar muni market or harbingers of a more worrisome trend: Cities becoming unwilling to service their debts, even if they have the means to pay, in order to make funding basic services or satisfying pension obligations a priority.
Heckman isn't too troubled by all this.
"The bankruptcy issues in California are specific to those parts of the state [where they've occurred], specifically inland California." he said. "Those communities didn't have any underlying fundamentals to fall back on when the housing bubble burst."
He added that there is actually good news coming for the state, as Fitch, one of the major credit rating agencies, recently announced that it may be upgrading California, which currently has one of the lowest debt ratings in the U.S. The passage of Prop 30 along with belt-tightening measures has put the state on a more sound future financial footing.
This contrasts with places like Detroit, a city that could be on the verge of a bankruptcy filing, where a perfect storm of high unemployment, population flight, and poor fiscal management, according to Heckman, could force Motown to join the ranks of Stockton and San Bernardino.
"But in the aggregate, the number of municipal bankruptcy filings are down this year," he said.
For what it's worth, in a low-interest rate environment, Heckman also sees stocks as a better investment overall than non-municipal bonds, but not because equities are necessarily staged for a massive rally.
"Corporations have lots of cash on hand to buy back stock and pay dividends," he said.
And he's right about that. Corporations are currently holding more cash on their balance sheets than ever before, close to $2 trillion.
Low interest rates, low inflation, and low growth. It's a challenging time to be a saver (and a good time be a debtor, given Bernanke & Co.'s ongoing cheap-money monetary policies). But the road isn't going to get any easier, particularly given the Fed's stated policies. So investors are going to need to stay on their toes and be prepared to focus on fundamentals.