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Fed’s Illusion of Prosperity Bound to Vanish

Investors should realize how irrational this all is. The United States is in a radical money-easing environment, in which the Fed is keeping interest rates artificially low while pumping money into the economy. This type of policy breeds speculative rallies. It inevitably results in boom-bust cycles such as the ones we saw in 1999-2002, 2006-09 and today. This is no time for short memories.

At best, the Fed has managed to create an illusion of prosperity, but it won’t last. And that should surprise no one who has followed the Fed’s activities over the past couple of years.

The Fed initially tried to create wealth by reviving the housing market through the first quantitative easing program (QE1), which concentrated on buying mortgage loans. But the foreclosure crisis and the massive excess supply of homes are once again weighing on U.S. real estate values and the Fed has largely given up on reviving that market.

Instead, QE2 has all been about forcing investors to rebalance their portfolios in favour of the stock market. The Fed has no mandate to do this, but it’s managed to get away with it by stating that its actions are intended to boost an inflation rate that is too low and veering dangerously close, at times, to deflation.

The Fed’s easy-money policies have helped to create inflation in commodities, foodstuffs and stocks. But given the high level of U.S. unemployment, incomes are unlikely to keep up with rising prices, so Americans will be forced to draw down personal savings to maintain their living standards.

Home prices are beginning to fall again and soon we will see the household sector having to rebuild its savings without aid from the government. The view that Washington can take care of everything will disappear with looming austerity, as state and local governments cut back on spending this year, followed by the federal government next year.

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