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Don't Count on a Fed Fix

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. The Federal Reserve is slated to meet next week and the pressure is on in light of a disappointing jobs report. A lot of folks are expecting the Fed to have some sort of additional quantitative easing program.

Here with me to talk about the implications and the tools that are left for the Fed is Morningstar's Bill Bergman. He is an equity analyst, and he is also a former economist at the Federal Reserve and a financial markets policy analyst.

Thanks for joining me, Bill.

Bill Bergman: Hi, Jason. Good to be here.

Stipp: The first question for you: a lot of folks, given that we've seen some economic indicators really weaken over the last few weeks, are expecting that the Fed might have to take some additional actions. The Fed for a long time had been saying that they're going to be keeping rates about the same that they were not going to be looking to tighten anytime soon, but now folks are talking about the Fed having to take additional actions to try to help ease what could be a slowing recovery.

My first question for you, rates are already close to zero, the short-term rates, what tools does the Fed have left?

Bergman: Well, they still have some tools that they have left that they've been using already, even though we have zero short-term interest rates now, but the Federal Reserve can also buy assets out there, and as you'd mentioned, quantitative easing, the Federal Reserve can go out and buy assets. That helps to create money in the economy.

The Federal Reserve, when it buys assets from the banking system or from the financial markets, what does it do? It takes those assets in; and what goes out, the Federal Reserve reserves, and money growth can happen as a consequence of that. So it's not necessarily clear that zero interest rates are things that stop monetary policy from working. But having said that, there are some constraints on the ability of the Fed to – there are issues going further down that route.

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Stipp: So, one of the things I know that has come up is the banks role in this, and banks' lending that happens here, and one of the things I think that we've heard from some banks is that, it's not the fact that they can't make loans; they can make loans, but they are saying that there is not a demand for the loans or they're not finding creditworthy borrowers to lend to. So they are saying that they have their hands tied.

What can the Fed do about that? How can they make the banks try to lend more and is it a good idea for them to do that?

Bergman: They can try to have the banks lend more money and they can provide incentives for doing that. For instance, on the regulatory policy side, they could ease up compared to where they've been in the last year. But it's not necessarily clear that that would be a good route for the Federal Reserve to take in the next year or so because of the problems that we've had in the past on the regulatory side.

We don't necessarily want the banks to get in trouble again by making bad credits. So forcing that to happen is ... we don't see that as something that's very likely down the road.

Stipp: Sure. Now a question for you as well is, if the Fed does come out with some sort of additional plan of action, could the implications of that, could it cause people to say, "Oh, wow, the Fed is now saying that things are worse than they thought" and it sort of builds this pessimistic atmosphere. Is there a concern that that could cause the markets to panic?

Bergman: There is a possibility that could happen, but I wouldn't give that a lot of plausibility or a lot of probability. Stepping back for a moment, I think it's probably safe to consider the fact that we shouldn't be too worried about what the Federal Reserve is going to do in the consequence of any slowing economy.

I believe the additional tools that they have are constrained and there's a debate over whether or not they should be exercised at this stage of the game. And maybe we shouldn't be too concerned about what the central planners that are controlling our money supply, given where they've – what we've done in the last few years is something that's been a consequence of the Federal Reserve monetary policy as well as regulatory policy leading into the crisis.

So, as investors, as business people, as consumers, as households, maybe not relying on this central authority that's theoretically out there pursuing maximum employment at stable prices, the mandate from the late 1970s Federal Reserve Act -- it is not necessarily clear we should be relying on that alone as something that's going to help us out.

The amount of productivity improvement that's being undertaken right now in our corporations, in our households, in our smaller businesses is pretty strong, independent of any Federal Reserve Policy, and that's going to be more important for recovery and for investments down the road.

Stipp: So, as an investor, if I do want to say, there are some things I can't predict or there are some things that you can't predict from Fed actions, what can I do to hedge my bets? I mean, obviously, it's still a very shaky environment out there.

Bergman: Jason, the answer there I think is fairly simple and yet difficult to exercise in practice. At Morningstar, we have the "moat" philosophy where we look for companies that are strong in their marketplaces with competitive advantages that lead to returns on capital in excess of the cost of capital over time.

And one thing that that can do, no matter what – I can't predict if we're going to have a deflationary period or a strong inflationary period; there is a debate over that. But as an investor if you seek out the companies that are well suited to do well in good times and in bad and can do well both in deflation, inflation, good companies, good solid companies with strong competitive advantages in the long haul are the ones that are going to fare well in either environment.

And the other contingency to prepare for is a recovery, which is still likely to be down the road, looking at some of the monetary conditions that we've had. We have interest rate spreads, spreads in the long-term rates over short-term rates today that are consistent with where they were in the 1992 recovery from the 1991 recession, as well as the recovery from the 2001 recession. We've got a very bold signal coming from those interest rates.

The amount of productivity improvement that we've had and the leverage that we have in our companies right now, there are ways in which confidence, I think, is going to build on itself in a way in the latter half of the year that we're going to see a recovery as well.

Stipp: Speaking of difficult plans to implement, you mentioned something to me earlier. Certainly, it's a difficult time for investors to try to put money back in the market with all the uncertainty out there, but you had an interesting thing that you pointed out to me looking at some past recessions. Can you explain a little bit about what you were meaning there?

Bergman: Sure. Well, if you put money into the S&P 500 every month since World War II, today you'd have a lot more money than you put into the marketplace because of the returns on equities since World War II.

But if you instead had not broken up your money into all those equal monthly chunks since World War II, but broke it up into nine equal pieces and only invested in the recessions in the nine recessions that we've had since World War II, you'd have more money today than you had if you were to just put money into the market continuously. Recessions can be a good time to be seeking out good quality companies and investing for the long haul.

In turn, in terms of the current environment where people are so concerned about the double-dip possibly happening, if you had broken up your money and only put all your money that you put into the market continuously since World War II into one year since World War II, what do you think the best year was?

Stipp: Well, I have to think, it must be the darkest of times since World War II, which would be…

Bergman: We've had a few dark years, but 1982 was the year that would be the best single annualized year for return on the S&P 500. Right during the double-dip, we had the 1980 recession which in turn followed by the recession in 1981-'82. And in '82 people had just given up their ghost, and that may be the best time for investors to be resolute about the long run.

If you believe the United States of America as well as the world has a future as a capitalist society, and I do, today is a good time to be seeking out good investments in the equity markets.

Stipp: Sure. Bill, just to bring it back to the Fed to close out, I think some good points there and some good pointers for investors, if you did have to try to guess what you think the Fed is going to be doing next week, what kind of policies they might come out with, what do you think is likely that they're going to say after their meeting next week and how they're going to be setting their policy maybe for the rest of the year?

Bergman: I wouldn't think we're going to have a major change from the last policy meeting. I think we'll have a similar statement. Having said that, one of the things the Fed does try to do is try to surprise people sometimes, and it's possible we have one of those. And that's not necessarily nefarious that Federal Reserve realizes that people can anticipate what it does, and sometimes it feels like it has more of an effect when it conducts activities that are kind of a surprise in terms of monetary policy.

We may get one, but I don't expect one. I think we've had a recent slowing, but not a dramatic one. And there is enough forward momentum, I think, in the economy that we're going to see the Federal Reserve stand pat more or less in the next statement.

Stipp: Bill, thanks so much for joining me and thanks for your insights.

Bergman: Nice to be here, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.