The Federal Reserve’s policy setting committee meets today.  Since their last meeting in January, consumer spending and labor market data have shown some encouraging improvement, but the Fed is unlikely to make any changes to their easy-money policies until the impact from global risks are better understood.

The impact from the devastating earthquake in Japan, the world’s third largest economy, is difficult to assess.  It will surely help damp the surge in oil prices that are attributed to unrest in oil-rich countries of North Africa and the Middle East, but both situations are sources of uncertainty.  Meanwhile, there are still sovereign debt concerns in Europe.

The U.S. faces several domestic headwinds as well, and Ben Bernanke told Congress earlier this month that he wants to be confident the recovery can stand on its own before withdrawing stimulus. 

What gets lost from time to time, however, is that the fed funds rate was effectively set at zero during the height of the financial crisis to combat an emergency situation.  But even as the crisis eased, the Fed continued to flood the market with liquidity for several reasons:

  * To avoid a repeat of the 1930s when the Fed did not provide sufficient liquidity.

  * To provide the financial sector with a way to rebuild their balance sheets by borrowing cheap from the Federal Reserve Bank and lending at higher rates to the U.S. Treasury (a more politically feasible way to recapitalize banks compared to a direct capital injection).

  * To avoid the painful de-leveraging process that typically follows a credit bubble bursting.

  * To inflate asset classes in order to restore consumer and investor confidence, thus stimulating consumer spending and investing.

Those with an economics background may dislike those reasons, and rightfully so.  The Fed’s policies were supposed to be emergency accommodations and we are well past that point – the time has come to slowly wind down the monetary stimulus.

I’m not looking for the Fed to explicitly say, “We’re raising the Fed funds rate” any time soon.  Instead, the first step is letting QE2 (the Fed’s purchases of Treasury securities) expire in June and stopping the reinvestment of maturing debt into new securities.  The next steps are more complicated and will involve some combination of paying interest on bank reserves kept with the Fed, reverse repo transactions, and selling some of the roughly $2 trillion securities purchased through quantitative easing programs (QE1 and QE2).

Once the Fed’s liquidity begins to drain, I don’t discount the possibility of a major market correction.  But there are dangers to keeping easy money policy in place too long.  The core inflation rate remains low, but a quick rise in inflation is not out of the question.  This could possibly force the Fed to react more aggressively, which could cause greater damage to the economy than a slow exit now.  Another risk of keeping “emergency” policies in place is that another unforeseen shock to the system would leave the Fed with few bullets to fight economic weakness.

Although the economy remains fragile, it is in a much better position than it was when Bernanke started floating the idea of QE2 last August.  There will always be risks and uncertainties, so it is difficult to envision a “good” time for the Fed to reverse its policies.  So to the Fed I say: there is no time like the present.

Peter Lazaroff, Investment Analyst

St. Louis, MO

www.acrinv.com