The Penalty We Will Pay for Today’s Interest Rate Policies

by Michael Lombardi, CFP, MBA

Two important statements from the Federal Reserve’s Open Market Committee meeting in Washington this week, what I think of them, and how they will eventually affect the stock market:

“Inflation will be subdued for some time.” I agree with this statement in that inflation is subdued for now, but it will be an issue going forward. The whole problem with this recession has been deflation. Prices for stocks and real estate have fallen. Wages have fallen. Lack of demand in various industries has pushed prices down.

Long-term, I expect inflation to be a big problem. Historically, if we look at any country, and we see the combination of a rapidly expanding money supply, very low rates for interest and ever-increasing government debt (we have all three in the U.S. now), inflation has followed with a vengeance. The stock market does not like rapid inflation, as it causes havoc with valuations.

Interest rates will stay at “exceptionally low levels” for an “extended period” of time. Yes, the Fed can keep immediate-term interest rates down, but it cannot control long-term rates or the bond market. The average 30-year rate for mortgages in the U.S. is 5.51%, the highest level since November 2008. We all know the stock market is allergic to higher interest rates.

The Federal Reserve has done an excellent job trying to revive this economy. But, like all economic initiatives, there are side effects that eventually develop. I may be proven wrong, but I sincerely believe that higher inflation and higher interest rates will be the long-term penalty to pay for the expanding money supply, low-interest-rate policy, and rapid government deficits we are enjoying today.

Michael’s Personal Notes:

For the first time since the end of March, short sellers, have increased their bets that the S&P 500 will fall in value. Short sellers make money betting that a stock or index will fall in value. From March 9 of this year, the S&P 500 has risen about 40%. Short sellers lost money since March 9 and obviously covered their short positions as the market rebounded. Now that the rally has stalled, short sellers are increasing their stakes that the S&P 500 will move lower again. Too early a bet for the short sellers? I think so.

Where the Market Stands:

Big rally for the stock market yesterday. After many market watchers had called the bear market rally over, the Dow Jones Industrial Average snapped back Thursday with a gain of 172 points, putting the bellwether index only 3.4% away from turning positive for 2009. Yes, stocks are overvalued. The Dow Jones is trading at 47 times earnings. But I’ve never seen a bear market rally end without a bang and that’s why I believe stocks have more life left in them.

What He Said:

“A Stock Market’s Obituary: It is with great sadness that we announce the passing of the Dow Jones Industrial Average. After a strong and courageous battle, the Dow Jones fell victim to a credit crisis and finally succumbed on Friday, October 3, 2008, when it fell decisively below the mid-point between its 2002 low and its 2007 high.” Michael Lombardi, in PROFIT CONFIDENTIAL, October 6, 2008. From October 6, 2008, to March 9, 2009, the Dow Jones Industrial Average experienced its biggest five-month point loss in history.