The Federal Reserve is one of the the most influential financial institutions. Its mandates are to maintain price stability, ensure the smooth flow of money, and act as lender of last resort in face of severe financial crisis. In order to understand the financial markets, it is important to understand the tendencies of this institution. It seems that the the Federal Reserve has an inflationary bias although not always a large one. If it were not for the integration of the global economy and the use of the dollar as the worlds reserve currency, inflation would be a much bigger problem. With the growing support for protectionism and dollar weakness, it seems that some of our saving graces may be coming to an end and we must question how we can protect our wealth. The fact that U.S. government does not seem to have any real desire to balance the budget does not make the Fed’s job any easier.

This is in no way meant to single out the United States because it is one of the better monetary systems currently in operation considering that it at least strives for some independence. The question remains: how independent is the central bank really? Whenever you put individuals in charge of monetary policy with very little explicit controls or restrictions, people are bound to hold them responsible for all the economy’s ups and downs. Is it beneficial in the long run to demand that the Fed lower interest rates and bail out reckless companies every time there is a threat of recession? Was it not that very situation which extended the housing bubble? Obviously, the lengthy terms of the Board of Governors may help neutralize potential outcries but to assume that the chairman of the Fed will live in a vacuum and not be influenced by the demands around them (whatever they are) would be a naive perception of human nature. It is also important to investigate where the Board of Governors would most likely hear their complaints from. Considering that the only people that the Federal Reserve actually does business with are wall street bankers which act as its primary dealers, it is not absurd to speculate that monetary policy would become slanted in their favor. Based on its current structure, it is an interesting revelation that the Federal Reserve System itself was conjured up in the early 1900’s by representatives of the largest privately owned financial firms which, in effect, appointed themselves as primary dealers.

One of the Federal Reserve’s main objectives is to maintain price stability. It is important to note that the Fed’s calculation of price stability has changed several times over the past decades, each time having the effect of lowering the stated inflation rate. It does not take a genius to determine that the figures are not indicative of reality when the price of almost every important product or service for the consumer has been rising much faster than the declared rate of inflation. To name a few, health care, education, food, and energy have certainly been rising more quickly than the stated rate. The Fed chooses to focus on the core rate of inflation, which excludes food an energy due to their volatile nature. If these were volatile but with a downward trend, such as computers, I doubt they would have been excluded. What about Housing? Why are rents factored into the index instead of actual sales prices? Should we start using auto leasing costs instead of sales figures as well? Again, I am not singling out the U.S. because it seems that all governments manipulate their figures to make them look better.

There is no question that the Fed has been happy to act as lender of last resort. The minute there is evidence of a problem, the financial community turns to the Federal Reserve for assistance and is almost always given it with very little extra cost or penalty. If you owe the bank $100 thousand, then it is your problem but if you owe the bank $100 million, then it is their problem. If the banks are owed $100 billion dollars, then it is the central bank’s and the government’s problem. The recent ploy by Citigroup Inc., Bank of America Corp., and JPMorgan Chase & Co. to pool many of their now illiquid assets into a $80+ billion structured investment vehicle seems to be nothing other than organizing their political clout so that they can receive one giant bailout package when the time comes to mark these assets down to their market value.

Although we have already seen some write-downs from financial institutions, I expect a lot more to follow. On November 15th, the Financial Accounting Standards Board is implementing a new accounting rule (FAS 157) that will put added pressure to declare the true market value for level 3 assets. Level 3 assets are the most illiquid of all assets on a firm’s balance sheet. Due to a lack of ready comparables, companies were able to value these assets based on in-house models. Marking these assets to their market value will be a long and painful process. Hopefully, we are close to halfway done. All the managers of potentially insolvent funds that have not been fired already are clinging by a thread and doing whatever they can to at least make it through this bonus season. Whether they even make it that long is irrelevant but you can be sure that they have no interest in recording their losses any sooner than they have to.

What does this all mean to the average investor? It probably means that as this financial tightening continues to unfold, the Federal Reserve and the U.S. government are going to concede to our nation’s banks and financial companies by offering assistance and increasing the growth in money supply at a time when almost every foreign central bank and sovereign wealth fund is slowing their accumulation of dollar denominated assets. Despite the recent comments by Ben Bernanke expressing his heightened concern on inflationary pressures, when push comes to shove, he is going give the banks what they ask for. The dollar is headed significantly lower across most currencies and commodities. Unfortunately, this will probably not help to solve the real problem, which is that during this credit bubble, capital was misallocated and now needs to be properly adjusted. The true power of capitalism rests in natural selection and allowing for the survival of only the firms that allocate capital most effectively to the benefit of consumers not politicians. By bailing out financial companies this early in the correction we only promote the same type of reckless speculative activity that caused the problem to begin with. In this case, I think a lesson can be learned from Japan: you do not get out of a recession by simply pouring money into the system, assisting the largest most politically connected companies and devaluing the currency. Unless we can somehow avoid the excessive booms and mal-investment that always occur, we need to get used to the idea that the economy should enter a contraction phase at some point and then we should allow the markets to do most of the work. Once the excesses have been able to work themselves out of the system, we might then think of providing some sort of stimulus but not before then.

Recommendations:
I am still recommending the stocks I did six months ago. Since my recommendation on June 4th, Proctor and Gamble (+11.9%)*, Johnson & Johnson (+4.1%)*, and McDonald’s (+15.9%)* have all significantly outperformed the S&P 500 (-4.5%)* but still have a lot of value and work well as a weak dollar and defensive play. Should the S&P 500 take a huge drop they may be dragged with it but such a situation would only present buying opportunities for these excellent multinationals with strong growth potential in emerging markets. I also like the Chinese yuan and the Japanese yen. For those that do not have access to these currencies through their brokerage account, Everbank.com offers a great service for buying these currencies. I am very positive on China’s currency because their trade surplus keeps going through the roof (27$ billion in October alone) despite high oil prices. They are facing heightened political pressure to allow faster appreciation (now even Europe is rattling its sabers). China’s finance ministers have made recent statements implying that they no longer favor the dollar as a reserve currency. The Yen has a lot of upside potential due to the unwinding of a carry trade (borrowing yen at very low interest to purchase higher yielding assets in other countries) due to risk aversion and a clear change in the directional trend of the currency. This unwinding process can happen very quickly and even at the time of the writing of this it is moving much faster than anticipated. I am negative on most financial stocks due to the large uncertainty regarding their balance sheets. For example, as a percent of equity in level 3 assets, Morgan Stanley has a reported 251% and Goldman Sachs has 185%. Goldman made a large timely bet against the sub-prime markets, which is already priced into the stock now. These and many other financial companies continue to face serious downside risk (even with a bailout) and must be approached with extreme caution.

*Calculated from closing price of June 4th 2007 to the close of November 8th 2007. Calculations exclude dividend payments.