11-18-2009

Punch Bowl Party

During the first quarter of 2009, the investing public was worried that we were falling off a cliff and into a new version of the 1930’s Great Depression.  With this in mind, it was easy for many investors to make the decision to put their money under the mattress.  Even though cash was yielding less than 1%, protecting principle was the focus.  At that moment, the pendulum that swings between fear and greed had pivoted well beyond its center of mass and approached the absolute end point of fear. 

Central bankers were also fearful at this point in time.  There was good reason to be fearful.  Credit markets had frozen and worldwide activity was in danger of slowing down dramatically.  Creative policy implementation, led mostly by our Federal Reserve System, prevented disaster and re-opened the commercial paper market and later allowed credit spreads to move back to normal credit market status. 

William McChesney Martin was an unusual and extraordinary fellow.  He graduated from Yale and started work on Wall Street at the inception of the Great Depression.  His work on re-regulating the stock market at the SEC landed him the job as President of the NYSE at the ripe old age of 31!!  Harry Truman made him the head of the import-export bank after World War II.  After serving as assistant treasury secretary and opening communication between the administration and the Federal Reserve System, Truman appointed him head of the Federal Reserve thinking he would have the FED in his pocket.  Boy, was he wrong!  Martin fiercely defended the FED’s independence.  Martin presided over the FED for two decades and made his monetary policy targets low inflation and economic stability.  Does this sound familiar?  He also figured out that to achieve this goal- a wide variety of indicators needed to be monitored.  This should also sound familiar. 

I know you’re thinking: why are we enduring this history lesson now?  Ironically, William McChesney Martin is most famous for one quote.  The history lesson is meant to establish credibility for the quote because of its source.  The quote, that most of you know is, “The job of the Federal Reserve is "to take away the punch bowl just as the party gets going,"^[1] referring to the need to raise interest rates when the economy is at its most active.

Many pundits profess that the Fed is abrogating its responsibility by keeping rates at zero as the economy recovers.  There is certainly a case that can be made that the reason that the stock market, gold, commodities and bonds have all done well is because the return on cash is so low.

In fact, it really is no secret that not only the FED, but all world central banks have not only supplied punch, but have spiked the punch bowl!  When the world withdrew from fear, it was left to the public sector to supply punch or risk the world economy dying of thirst. 

The issue is whether the punch bowl been out too long, or whether it has been spiked with too much grain alcohol.  The corollary concern is that some governments have been more effective in their spending of funds for fiscal stimulus than others and that the monetization of the debts arising from this spending will become inflationary. 

In our opinion, inflation will arise from government bond issuance crowding out private borrowing and necessitating higher interest rates over the next few years.  The issue is that we can think faster than things occur in the real world.  The inflation probably isn’t coming until 2011 or 2012.  It’s early enough to plan for, but not early enough to worry about it popping up in market action. 

The thing we do have to worry about materializing in near term market action is the removal of the “punch bowl”.  If it was possible, I would hold a séance and channel Chairman Martin to ask him if we’re keeping rates too low for too long.  Since this isn’t possible, I will interpret from his comments and actions what I think he would say. 

The punch bowl stays until the party gets out of hand.  That doesn’t mean that you take it away when you think it might get out of hand years from now.  We certainly don’t have a backdrop of an active economy threatening an imminent return to inflation.  Chairman Bernanke is protecting the economy from a double dip and probably will until he’s sure that we are past the danger of an aborted recovery. 

While the punch bowl is present, the U.S. banks have a freebie carry trade to rebuild capital and most investors are certainly looking for a place to invest their zero return cash.  Stocks, gold, commodities and bonds will continue to be the recipient of these flows. 

1) http://en.wikipedia.org/wiki/William_McChesney_Martin,_Jr. 

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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