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The Fed Is Not Prepared for the Next Crisis

The Federal Reserve, like all modern central banks, has traditionally relied on a specific policy toolkit to moderate the business cycle, as well as combat crises and recessions. Chief among these is its control of interest rates. By cutting interest rates, the Fed can juice up demand, while raising rates can cool down an overheating market.


Unfortunately, despite stocks continuing to hit all-time highs (and with the current economic expansion more than a decade old), the central bank has actually been lowering interest rates. That has created a dangerous situation.

Running out of firepower

With rates low, the central bank has little firepower to combat a recession by conventional means, a problem highlighted in July by Ray Dalio (Trades, Portfolio), the legendary hedge fund manager and founder of Bridgewater Associates:


"When the Fed shifted to a much easier stance, it made sense that both interest rates fell -- which was good for bonds -- and stock prices rose. But the power to do this is limited. Think of central banks cutting interest rates and purchasing financial assets (QE) as shooting doses of stimulants into their economies and markets...All told, monetary policies will be dangerously low on power in a couple of years when the next downturn is more likely to come."



The Fed appears to be committed to keeping the expansion going, no matter the eventual consequences to both financial markets and the broader economy. As I discussed in the first part of this research piece, the longer the inevitable correction is delayed, the worse the eventual correction will be. Using up essential firepower now is a dangerous - and short-sighted - strategy, yet the Fed under Chairman Jerome Powell now appears committed to standing by it.

With its usual tools extremely limited, the Fed is now considering more radical methods of sustaining the current expansion and limiting money market volatility, as well as perhaps fighting a future recession. For example, according to a Jan. 4 Barron's report, the central bank is now considering whether to adopt a permanent standing repo facility. As I discussed in a September article, the Fed's mounting forays into the repo market should be cause for concern among all conscientious investors.

The Fed says everything is fine

Strangely, the U.S. central bank has continued to present an optimistic outlook, despite the mounting signs of trouble, from troubling repo market data to yield curve inversion. The Fed is reportedly content to keep interest rates flat throughout 2020, an unusual move for an economy supposedly firing on all cylinders.

The Fed seems to believe that keeping rates unchanged for the foreseeable future will be helpful to its management of monetary policy. On Jan. 9, Minneapolis Fed President Neel Kashkari opined that he does not foresee a recession in the next year or two, claiming the central bank to be in a "much better position" to boost inflation to target levels thanks to its holding off on rate adjustments.

Former Fed officials have lauded the central bank's recent moves. Last week, former Chairman Ben Bernanke argued that controlling inflation is of paramount importance and that the Fed's new tools will provide sufficient firepower to weather any unexpected economic storm:


"Low inflation can be dangerous. Consistent with their declared 'symmetric' inflation targets, the Federal Reserve and other central banks should defend against inflation that is too low as least as vigorously as they resist inflation that is modestly too high. The new policy tools are effective. Quantitative easing and forward guidance can provide the equivalent of about 3 additional percentage points of short-term rate cuts."



Verdict

Bernanke and his successors are painting a rosy picture of the Fed's ability to make accurate forecasts and deliver effective policy. Yet, investors should remember Bernanke's own words on Jan. 17, 2008:


"The Federal Reserve is not currently forecasting a recession."



Of course, we now know that the Great Recession had already started by that point. Clearly, the Fed has not always been successful, either in predicting the occurrence of a recession or in mitigating its effects.

With capital markets running hot in spite of trade war headwinds and a long-in-the-tooth economic expansion, it would be prudent to view the Fed's guidance with a healthy degree of skepticism. Warren Buffett (Trades, Portfolio) certainly seems to be getting ready for a storm. Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has been building up a massive cash pile over the past couple quarters.

It seems that the Oracle of Omaha is keeping his powder dry. Wise investors will consider following his lead.

Disclosure: No positions.

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Read more here:

  • Yield Curve Inventor Warns Investors to Prepare for Recession
  • This Small Telecom Stock Is Aiming for a Big Turnaround
  • The Fed Is Sleepwalking Toward the Next Recession, Pt. 1


This article first appeared on GuruFocus.