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Time to Take Off the Training Wheels

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Recent economic data, from employment to manufacturing to consumer spending, suggest an economic recovery is firmly afoot. This type of economic revival was certainly not a foregone conclusion just two or three years ago. Amid the renewed optimism, it is easy to forget that we recently endured the worst recession since the Great Depression. But while the economy certainly has ongoing challenges ahead (employment and housing come to mind), the preponderance of evidence does suggest that the worst is over and we have reached escaped velocity. Such a recovery would not have been possible without the aggressive action on the part of Ben Bernanke and the Federal Reserve.

During the throes of the financial crisis, the Fed acted decisively using the only tool at its disposal -- monetary policy. Its actions included lowering the Fed Funds rate to near zero as well as several rounds of "Quantitative Easing." The Fed's intervention restored stability to the capital markets and banking system, and their continued support ultimately contributed to a rebound in consumer confidence. But while an undisputed success, the Fed's actions are not without negative side effects and risks. These potential landmines would suggest that it is time for the Fed to stand down now that the pump has been successfully primed. The Fed succeeded in rescuing us from crisis; it should not attempt to rescue us from all consequences.

The Fed's Quantitative Easing, which refers to the large-scale purchase of bonds by the central bank in an effort to reduce long-term interest rates, was designed to achieve a couple objectives. First, the bond purchases add liquidity to the banking system so that banks will increase lending activity and stimulate economic growth. Second, lower interest rates force investors into riskier assets in search of better returns. While bank lending has yet to rebound in significant fashion, it is clear that asset prices have been strongly supported. The major stock indices are up over 100 percent from their March 2009 lows, and housing prices are beginning to stabilize thanks to very low mortgage rates. Armed with portfolio gains, many consumers are coming out of their shells to spend once again.

The evidence is clear that Bernanke has been targeting housing and stock prices through monetary policy. In defending his aggressive monetary policy, Federal Reserve Chairman Bernanke explained:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

But there is a downside to targeting asset prices through monetary policy. The most obvious problem, manifested in the "Occupy Wall Street Movement," is the economic inequality that is created. The wealth gap between the rich and poor, already at the highest levels since before the Great Depression, has expanded as stock prices have soared over the past three years. Effectively, the Fed's monetary policy represents another iteration of Reagan's famous "trickle-down economics." In supporting asset prices, the Fed is hopeful that higher stock and real estate values will eventually benefit more moderate-income consumers through increased investment and job growth. The idea, as Bernanke noted in his op-ed, is to create a virtuous cycle of investment, improved confidence, and higher spending that benefits all. However distasteful it may be that the cycle begins with the "rich," the Fed has been sincere in its efforts to seek the most efficient and impactful solutions to our economic crisis.

Ultimately, however, the Fed's monetary policy (and resulting higher asset prices) alone cannot deliver us from evil. According to Naples LH Fleming realtor Byron Vogel, "Collier County properties in the $200,000 range fell further and have recovered less than those above $750,000." Higher stock and housing values feel really good for those of us fortunate enough to benefit, but a more widespread economic recovery needs a much firmer foundation. This foundation must include widespread job growth, expanding incomes, a clearing of the foreclosure backlogs, higher savings rates, improved access to credit, and improved confidence. These things cannot be achieved through monetary policy alone, no matter how aggressive.

The root of our economic problems is too much debt. Therefore, the economy can only return to a state of sustainable growth through a long, slow process of consumer and government deleveraging. This process also cannot be expedited by loose monetary policy. In fact, it can be argued that low interest rates are counterproductive as they encourage the assumption of more debt and can lead to new asset bubbles and more widespread inflationary pressures.

Moreover, the Fed has created a problem of moral hazard with investors expecting additional Fed action whenever markets swoon. With the housing bubble so fresh in everyone's minds, the Fed's continued "pedal-to-the-metal" approach to monetary policy is confounding.

The Fed's monetary manipulation cannot go on forever. It would be nice if the Fed could simply use monetary policy to return us to full employment and economic health. However, this is impossible. Nobody can predict when, but the unregulated nature of the Fed's limitless printing press will at some point undermine the value of the dollar and ignite an inflationary surge.

It seems likely that we are nearing the end of the Fed's "highly accommodative stance" for monetary policy. Recent increases in bond yields represent the writing on the wall. We cannot continue to receive positive employment and other economic data while also receiving the promise of indefinite Fed support. We are unsure Collier County residents or the markets are prepared for a reversal in Fed policy. Are you?