Summary – When You’re a Hammer, Everything Looks Like a Nail

The Fed announced another round of “quantitative easing” in the form of $40 billion of mortgage

purchases per month until the labor market “improves substantially.” The stated goal is to “increase policy

accommodation” by driving down the cost of borrowing not only in the mortgage sector, but in other areas

as relative valuations adjust.

Following Maslow’s observation on problem-solving, the Fed continues to drive down the cost of funds,

punishing savers, with the hopes of igniting activity by borrowers. But the holdup in our economy is not

due to a high cost of funds, but a great deal of uncertainty.

By leaving this latest version of QE open-ended, they are adding to financial uncertainty while at the same

time providing little to no value in the form of lower interest rates. In addition, the further the Fed delves

into these new policies, the more complex and fraught with danger any exit strategy becomes.

But the Fed is a “hammer,” and only sees a “nail” in the form of today’s economic challenge. It does not

understand that a screwdriver, or hacksaw (or Congressional harmony!) may lead to a better resolution.

What’s Important…

What’s the point of QE3? With mortgage rates at all-time lows of 3.5 percent, why would another 0.25 or 0.5

percent make any difference? I think this actually misses the question. The Fed has painted itself into a

corner that would drive rates significantly higher if they didn’t initiate QE3.

Relative value (of the dollar) is part of the equation. Given extensive easing of monetary policy around the

world, particularly the ECB President’s promise to do “whatever it takes” to assist their economy, more

policy accommodation in the U.S. helps keep the dollar in a competitive position. This should only be a

side benefit, however, as projecting out this sort of philosophy quickly leads to a “race-to-the-bottom”

scenario where no parties win.

Rates to remain “exceptionally low” until mid-2015. Another change to monetary policy was the extension of

the Fed’s “promise” to keep rates at these levels until mid-2015 from “late 2014.” Many argue this extended

period language keeps potential borrowers on the sidelines as they delay decisions affecting the economy.

But my guess is if people have a way to borrow, invest, and make profits, they will not delay those actions.

Instead, there simply aren’t that many positive NPV projects available today.

Quick Hits: The Fed September 14, 2012

What to Look for…

The marginal utility of continued monetary policy easing will come to the forefront in coming months.

To date, the Fed has lowered rates 5 percentage points and grown its balance sheet by $2 trillion, with

possibly another trillion on the way. In this week’s announcement, they open the door for continued

balance sheet growth seemingly without end. But the market does not believe this will solve our economic

problems. If it did, interest rates would trade higher in anticipation of an inflation-fighting Fed in the

future.

Instead, investors and pundits will soon come to realize the Fed is not the all-powerful being it’s made out

to be. Congress, through fiscal and other legislative policy, has a tremendous influence on the economy as

well. As we struggle through the rest of this election cycle, the debate will shift from “what should the Fed

do?” to “what should the rest of Washington do?”

Or at least, that is my hope.

A Picture is Worth…

Source: Bloomberg Written by:

Joe Morgan Chief Investment Officer SVB Asset Management @SVBJoeMorgan jmorgan@svb.com © 2012 SVB Financial Group.SM All rights reserved. Silicon Valley Bank is a member of FDIC and Federal Reserve System. SVB>,

SVB>Find a way, SVB Financial Group, and Silicon Valley Bank are registered trademarks. SVB Asset Management, a registered

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Size of Fed Balance Sheet