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Inflation Question, Bond Exit Fees Raise Debate over Fed Policy

Jeff Benjamin
Investment News
June 27, 2014
The decibel level of the debate over whether — or how much — the Federal Reserve has painted itself into a corner with its quantitative easing program has increased several notches after the idea of the government adding exit fees to bond funds was floated.

Last week, reports surfaced that Fed officials had discussed the notion of placing exit fees on bond funds to prevent a run on them when interest rates rise. Fed chair Janet Yellen said she hadn't heard about the idea but her comment didn't stem speculation and debate.

“Instead of admitting they screwed up, now the Fed is trying to figure out a way to raise interest rates and keep people trapped in money-losing investments,” said Peter Schiff, chief executive and chief global strategist of Euro Pacific Capital Inc.

“People only bought bond funds because of the Fed's policies,” he added. “Now the government is trying to figure out how to force people to do the wrong thing by forcing them to go down with the ship when rates start to rise.”

In addition to the exit fee, which most observers doubt will see the light of day, Fed watchers are growing increasingly uneasy over what appears to be a flexible definition of inflation that somehow feels worse than it looks.

The personal consumption expenditure index, the Federal Reserve's preferred inflation measure, rose 0.2% in May to 1.5% year-over-year. The PCE inflation measure is now at its highest 12-month rate since October 2012. Meanwhile, the more comprehensive Consumer Price Index rose 0.4% in May and is showing a year-over-year gain of 2.1%.

Most analysts don't really expect the Securities and Exchange Commission to suddenly rewrite laws to add exit fees to bond funds, and Federal Reserve Chair Janet Yellen acknowledged that she was not familiar with any such plan, but the mere notion of such fees underscores the unprecedented status of the Fed's monetary efforts.

“It sucks to be the Fed right now, because they're all out of tools and now own more than $4.3 trillion worth of long-dated Treasuries,” said Scott Colyer, chief executive and chief investment officer at Advisors Asset Management.

“The Fed has done a lot of quantitative easing and they haven't seen a lot of value from it, aside from inflated asset prices,” he added. “They've been trying to create inflation to counteract deflation, but we still have no monetary velocity.”

That lack of monetary velocity, despite six years and $4.3 trillion worth of quantitative easing, is what critics say keeps the Fed from acknowledging inflation as a serious risk in the economy.

“Right now the Fed is the midst of the most radical experiment in history, and it is way out in uncharted territory,” said Michael Aronstein, manager of the $20 billion MainStay Marketfield Fund (MFLDX).

“There are consequences to radical policy, and they often take a long time to manifest, and people don't always see the cause and effect,” he added. “For all the intelligence there, the Fed has no prognostic insight and they haven't yet figured out the difference between walking a dog and walking a tiger.” The Fed's current course has been heading this way, like a giant locomotive, since the start of its quantitative easing program six years ago, a move designed to help pull the economy out of the great recession.

The QE program is technically being wound down, with the Fed's $85-billion monthly bond-buying program now down to $35 billion per month. But reducing the pace of bond-buying is only one small first step.

As Mr. Schiff breaks it down, that $35 billion is probably closer to $50 billion worth of bond purchases when reinvested interest and matured bonds are included. Plus, the Fed's giant bond portfolio is likely earning at least $40 billion annually, which is also being reinvested into bonds.

“Even if they were doing no quantitative easing, the Fed would still be a big buyer of Treasury bonds,” he said. “I understand what the Fed is doing, I understand what the problem is and I understand that everything the Fed does makes matters worse.”

While there are plenty of folks in Mr. Schiff's camp, convinced that the Fed has created an unavoidable path toward serious and potentially uncontrollable inflation, there are also those who believe the Fed can manage its record balance sheet without imploding the U.S. economy.

“The Fed is not under any time pressure, they don't have to show a profit or a loss and there's no clock for their exit out of quantitative easing or their balance sheet,” said Robert Tipp, chief investment strategist at Prudential Fixed Income.

“The economy is a system of inputs and outputs and if the Fed sees the economy overheating, they could think about the best way to tighten financial conditions; they could sell some of their longer-dated bonds,” he added. “I actually think it's a lot harder to get sustained inflation in a developed economy than a lot of people think.”

Mr. Colyer, of Advisors Asset Management, doesn't see it that way.

“The Fed is worried about the greater evil of deflation and tells us not to worry about inflation because they know how to deal with it by just raising interest rates,” he said. “The trouble is, they only think they have the solution to inflation but the history of quantitative easing has never worked, and it's certainly never been tried on this kind of scale.”

While it has never been tested at this level, economic historians typically cite former Fed Chairman Paul Volcker's aggressive inflation-busting move in the early 1980s.

With inflation at 13.5% in 1981, Mr. Volcker pushed the Fed fund's rate to 20%, which is credited with helping to drive inflation down to 3.2% by 1983.

But these are different times. The Fed is using a different measure to calculate inflation, investors have poured billions into bond mutual funds that will get crushed in a rate-hike cycle, and the U.S. government has amassed nearly $18 trillion worth of debt that can only be managed with an inflated dollar.

“Volcker taught the world how to beat inflation by just raising interest rates,” Mr. Colyer said. "They aren't worried about inflation because they think they have the answer. The problem is a 20% Fed fund's rate is very painful for the economy.”