Market Sells Off on Fed Inaction

After three years of easy money the Federal Reserve announced yesterday that it was going to buy around $10 billion a month in treasury bonds - a pittance for an economy the size of the United States. The Fed began its current stimulus campaign with a discount rate cut in August 2007. After using every trick in the book and creating a few new ones, the U.S. economy is still in a troubled state.

In its statement after yesterday's meeting, the Fed admitted that 'the pace of recovery in output and employment has slowed in recent months' and 'bank lending has continued to contract.' The FOMC went on to say that 'the the pace of economic recovery is likely to be more modest in the near term than had been anticipated.' Considering that the Fed was hopeful of preventing a recession in the spring of 2008- months after a recession had already started, these statements imply that the U.S. economy is close or even in a downturn.

The Fed doesn't plan on doing much about it however. It can't lower the funds rate any further because it is has been at zero since December 2008. The major option the Fed has left to stimulate the economy is to expand its balance sheet through quantitative easing, essentially money printing. This would be inflationary as is the case with all forms of money printing. While the Fed constantly says there is no inflation and intimates that it is worried about deflation , it is unwilling to make a move that would be inflationary. If deflation is really a risk, expanding its balance sheet becomes the correct course of action. Investors should wonder why the Fed is unwilling to do this.

What the Fed plans on doing currently is to buy 2-year and 10-year treasuries with the proceeds it gets from selling mortgage backed securities that it acquired from Fannie Mae ( FNMA ) and Freddie Mac ( FMCC ) during the Credit Crisis . The Fed has more than a trillion dollars of these on its books. This action will prevent the Fed's balance sheet from contracting. The net purchase in treasuries will be minimal. The overall impact on the U.S. economy will be close to nil.

Investors should look to Japan (NYSEArca: EWJ) for a lesson on how inept central bank and fiscal policy can lead to decades of a failed economy and low stock prices. The Nikkei closed at 9213 last night, more than 75% off from its high around 40,000 on the last day of 1989. The Japanese economy has been in the doldrums for two decades now. In the United States, it's three years and counting.

Disclosure: No positions.

Daryl Montgomery

Organizer, New York Investing meetup

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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