The Rise of the Active Fed

 | Jul 16, 2014 | 3:00 PM EDT
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The ultimate responsibility of each individual or corporate entity is to itself, and this includes the U.S. Federal Reserve system, along with its 12 regional Fed banks and board of governors.  

In coverage of the 55-page semiannual Monetary Policy Report the Fed supplied to Congress yesterday, the financial media chose to focus their attention almost solely on two passages, referenced below.

On page 20 in the section on recent economic and financial developments, the report noted:

"Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Nevertheless, valuation metrics in some sectors do appear substantially stretched -- particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year. Moreover, implied volatility for the overall S&P 500 index, as calculated from option prices, has declined in recent months to low levels last recorded in the mid-1990s and mid-2000s, reflecting improved market sentiment and, perhaps, the influence of 'reach for yield' behavior by some investors."

This was noted again two pages later in the same section, under the subsection titled "Developments Related to Financial Stability" and noted as:

"Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms."

The financial media's unanimous response to these observations was that it is inappropriate for the Fed to be commenting on the performance of the private capital markets, especially specific sectors.

Putting aside the appropriateness of offering such observations, the more important issue is that the Fed is and has been incrementally exhibiting a willingness to discuss financial issues concerning both public- and private-sector actions, especially since the 2008 financial crisis.

The germane point is that this is not a one-off issue or an unintended error. It is a continuation of a trend, and investors should expect observations to increase from the Fed concerning all asset classes, as well as legislative and fiscal policy.

Ben Bernanke became the first Fed chair to be openly and repeatedly critical of fiscal policy decisions, an area that historically the Fed did not comment on.

The Fed's growing frustration with the actions being taken by fiscal authorities as well as by the private-sector banks and commercial markets in general has been growing for years now. This puts the Fed in a situation where it feels it must acknowledge it publicly.

The reason is that both the public- and private-sector financial leaders have assumed that the Fed would simply supply whatever monetary support was required and that there is no limitation to what that might be.

I addressed this issue three years ago in the column "The Honey Is Gone" and followed that up a month later in the column "Mission Creep in the Central Banks." I suggest reading them both in order to get a better feel for what the Fed is dealing with and why it is becoming more vocal about issues it used to not comment on publicly.

In short, the Fed is running out of monetary policy options to support the economy, and it needs the banks and elected officials to understand that and stop taking monetary largesse for granted.

Additionally, the Fed has been growing frustrated with the banks' gaming of quantitative-easing programs that were designed to stimulate housing activity, as I discussed last week in the column "Quantitative Easing Is Not Going Away." The Fed is also getting fed up with the banks apparently deliberately misusing the public tools available for accessing economic activity, as I discussed yesterday in the column "The Rise of 'Nowcasting' Economic Activity."

The bottom line for investors, traders, pundits and elected and appointed officials is that complaining about the Fed's increasing commentary concerning fiscal policy or the capital markets serves no purpose.

This is a trend that has been gaining inertia for the past several years, and investors should anticipate that it will accelerate from here.

Having said all of that, the Fed is not going to start taking an adversarial position with the banks it is supposed to support and regulate. The banks, especially the Big Four (JPMorgan Chase (JPM), Citigroup (C), Wells Fargo (WFC) and Bank of America (BAC), are for all practical purposes the Fed's bosses.

It is probable, however, that Fed Chair Yellen and other Fed governors and Fed bank presidents will begin commenting more publicly and critically about fiscal policy and about political discord between the parties. 

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