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Federal Reserve Policy Change Could Fool Investors

For anybody trying to plan their financial future, nothing is more important than what the Federal Reserve does next.

The Fed's easy-money policies, which have been in place for more than four years, have helped stabilize home values and push the stock market to new highs. At some point, the Fed will have to change course and rein in the liquidity it's been injecting into the economy. That will be a pivotal moment that tests whether the stock market, the housing market and other sectors of the economy can stand on their own.

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Fed officials are growing more concerned about the possible harm caused by too much easy money, such as runaway inflation and asset bubbles. The minutes of the Fed's latest meeting show the strongest sentiment yet in favor of slowing the rate of bond buying, known as quantitative easing, that has propped up stocks and pushed interest rates to record lows. "From the looks of it, most Fed participants want to scale back or end bond buying this year," forecasting firm IHS Global Insight explained in an analysis of the latest minutes.

The textbook market response to QE "tapering" would be for interest rates to rise, since the Fed would be buying fewer bonds and effectively increasing bonds supply on the open market. If supply increased and demand remained the same, interest rates would rise because bond issuers would have to pay higher rates to attract buyers. And in fact, many Wall Street firms are predicting rising interest rates later this year, which would increase the cost of buying a home or car or taking out any kind of long-term loan.

But the opposite could happen if the Fed begins tapering QE too soon. "A premature end to QE would have negative consequences for growth and financial markets," IHS believes. "Equity prices would fall and, counterintuitively, bond prices would rally, sending interest rates lower."

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Here's why that might happen. Many investors believe the Fed's policies have been the most powerful tool, by far, in helping the economy recover from the 2008 financial shock. Even now, the Fed's easing is softening the sting of tax hikes and spending cuts that might be far more damaging were the Fed not so intent on nursing the economy. So if the Fed changed course sooner than expected, it might be viewed as a global shock similar to a flare-up of the European debt crisis or a conflict in the Middle East that sent oil prices skyrocketing.

During those types of shocks, investors typically sell risky assets like stocks and flee to safer assets such as Treasury securities, which increases the demand for bonds, pushing rates down. It's hard to tell exactly how much the flight to safety would counteract the rise in rates triggered by Fed action, but it's clear that virtually every time investors get the jitters, they pile into bonds and rates fall.

The key issues, therefore, are when the Fed decides to tighten its policy and how much advance notice it provides. The Fed has already said it will continue its easing policies until the unemployment rate, now 7.6 percent, approaches 6.5 percent, as long as inflation remains under control. So a policy change might still be a long way off, despite speculation of an earlier exit. Bank of America Merrill Lynch told clients recently that it thinks the Fed will continue to ease until the first half of 2014, and then gradually slow its pace of bond purchases.

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Weakening economic conditions could give the Fed plenty of reason to keep pumping the painkillers. The latest job-creation numbers were much weaker than expected, and some economists think they could get even worse during the next few months, as the full force of tax hikes and federal spending cuts enacted this year hit the economy. Many Wall Street analysts are also expecting a stock-market correction of 5 to 10 percent, which would further undercut confidence.

The Fed's latest meeting took place before the discouraging March job numbers came out, so the next time the Fed meets to review its strategy, it will have gloomier data to consider. That might be all it needs, for now, to stay the course.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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