The Fed's Delicate Balancing Act

The Federal Reserve kept its near-zero short-term interest rates unchanged last week, and that lack of action has our pundits wondering how long the Fed can pretend it’s not worried about inflation before that, too, becomes a factor in the complex and slow road to recovery.

After listening to Wednesday's Federal Open Markets Committee statement, market strategists and economists concluded that if Fed chairman Ben Bernanke and his colleagues had their way, we'd stop worrying about inflation. After all, the longer-term absence of inflation, kept in check so far because people just aren’t spending much money, would be ideal for getting the economy out of its current mess: 10-year Treasury yields would remain low, the modest pace of housing activity would continue, and investors would be at least mildly positive about our economic prospects.

However, such a scenario may be tenuous at best. According to our pundits, the Federal Reserve is trying to strike a delicate balance by using non-committal statements, such as "the pace of economic contraction is slowing" and "conditions in financial markets have generally improved in recent months." The goal, our pundits say, is to keep bond investors from driving up yields and derailing the low mortgage rates that are helping the recovery in housing. They also hope to stimulate enough growth in the economy that it will rely less on stimulus money.

ISI Group policy analysts, Andy LaPerriere and Tom Gallagher, explain the Fed's difficult position. The Fed, they argue, has to stay vague, offering near-term reassurance that rates aren’t in danger of going up without making the stimulus plan look open-ended.

"We don't think the Fed wanted to encourage market pricing of late '09-early '10 rate hikes; instead, it probably wanted to avoid direct longer-term guidance," they wrote. The analysts believe the Fed will rely on future testimony from Bernanke to more clearly signal that it won't hike rates for a while.

LPL Financial chief strategist Jeff Kleintop says he sees some promising signs that the markets are undergoing a healthy recovery and becoming more stable. "The fact that this process is taking place without explicit policy action demonstrates that the markets may be coming off of the Washington life support machine," he wrote.

Barry Knapp, U.S. strategist for Barclays Capital, thinks this indicates a "credit-less" recovery, meaning we’ll see smaller, less leveraged growth as investors try to steer clear of repeating the bubble and bust cycle. Such a recovery, he says, may be mild but runs less risk of being powered by cheap capital and overextended borrowing.

“The key macroeconomic question is whether the economy can recover with capital restrictions and credit contraction. There is precedent for a credit-less recovery,” he wrote on June 25. “In the case of the recession ended March 1991, bank asset growth fell 1% in 1991 and was flat for 1992; however, GDP averaged 2.7% for the four quarters following the recession and 3.2% for the subsequent four quarters.”

Ron Muhlenkamp, the founder and president of investment firm Muhlenkamp & Company, sees similar parallels to the early 1990s. He projects that, like the recession of the '90s, it could take a couple of years for consumer confidence to return.

"This time around, with the problems in our credit markets and financial institutions, it wouldn’t surprise me if consumer confidence stays modest – subdued – for a long time coming out of this recession," he wrote in his June Sign Post commentary. "But, remember, the economy may come back long before a return of consumer confidence, similar to what happened after the 1990 slowdown. Public perception lags the economist’s definition and the markets anticipate the economist’s definition. That’s just the way it works."

So how should investors play this complicated state of affairs?

According to a June 25 report by JPMorgan strategist Thomas Lee, this might be a prime time to get in early on cyclical stocks, such as consumer discretionary companies, technology, industrials and materials. He cautions, however, that rising oil prices and the recent three-month stock market rally could translate into a possible correction in September.

Brad Sorenson, the director of market and sector analysis at Charles Schwab, sees it as a chance for investors to shake off their paralysis."[In] every situation lies an opportunity: Investors looking to make some shorter-term moves could benefit from buying stocks and funds at lower prices," he wrote on Thursday. "We continue to believe that global reflationary policies, combined with the possibility of a continued weakening of the dollar will benefit the more cyclical technology, industrials and materials sectors."