David Malpass, Chairman of Encima Global, LLC and former Deputy Assistant Secretary of the Treasury, wrote the following analysis of the Fed’s decision announced on August 9, 2011 to maintain extraordinarily low interest rates at least into 2013.  He also provides some insights into the likely outcome of deliberations by the super committee set up to make further reductions in the spending under the deal to raise the debt ceiling.  The article is succinct and worth reading.

Weak Fiscal and Monetary Policies Kick the Can Into 2013
By David Malpass

In its statement today, the Fed emphasized the weakness of the economy and deepened its commitment to near-zero interest rates, almost conceding a Japan-like malaise. “Economic conditions… are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

  • Unless there’s a strong economic surge, this will delay a rate increase past the November 2012 election and almost to the end of Dr. Bernanke’s second term as Chairman. (It ends in January 2014 with consideration of any successor beginning in mid-2013.) There were three dissenters (Plosser, Fisher and Kocherlakota) who preferred the previous language about fed funds at exceptionally low levels for an “extended period.” The Fed said “longer-term inflation expectations have remained stable.”
  • We think the Fed’s long commitment to a near-zero rate is anti-growth. The policy has already been in place since the end of 2008 without working to encourage growth, investment or jobs. The weak monetary policy pushes growth capital away from the dollar and investments in the U.S. The policy severely disrupts short-term credit markets and allocates credit through regulation rather than price.
  • The dollar sold off hard on the Fed’s announcement. The DXY index broke below the 74 level as equity markets closed and is not far from the May low of 72.7. With the U.S. following a distinctly weaker monetary policy than almost all other central banks, we expect current trends in favor of commodities and foreign to resume. We think the turmoil over the debt limit, the S&P downgrade, Europe’s debt and the equity sell-off will subside. We note some similarities to the 1987 market crash in which corporate stock buybacks helped restore confidence (buybacks began making headlines this afternoon.)

On the fiscal side, Washington is already downplaying expectations for the super committee. The new committee will be mostly mechanical, not conceptual, seeking to agree on a few spending cuts through majority vote and reaching only a portion of the $1.5 trillion ten-year deficit reduction goal. The sequester isn’t scheduled until January 2013, so it can be changed after the 2012 election in order to avoid the proposed stiff cuts to defense and Medicare. The net result is to maintain massive spending through at least 2013.

Outlook: As discussed in our pieces all year, we expect ultra-loose fiscal and monetary policy to continue for the foreseeable future. We think they are harmful to growth. They tend to weaken the dollar, divert investment into gold and commodities and benefit emerging markets over the U.S. We think the U.S. is in an extended soft patch (worse than we thought) but not heading into recession. Like the 1987 stock market crash, the sharp August equity sell-off may reverse over time given good profit expectations and massive corporate liquidity (the stock buybacks started today). A key variable is whether banks remain under the threat of having to raise sizeable new equity capital during economic and market weakness.