Farr: The Fed is Creating Moral Hazard

Federal Reserve intervention in the economy has profound implications for not only the prices of goods and services, but also financial assets.

The Fed has kept the Fed Funds rate at close to zero for over three years now, with a promise to remain low at least through the middle of next year. As a result, investors across the globe are forced into risky assets that offer better return potential.

This rotation of money into stocks, commodities, high yield bonds, real estate, etc, has lifted the prices of these assets relative to where prices would be otherwise. And higher asset prices have been supportive of our economic recovery.

However, the Fed’s action does not come without risk.

Many economists believe that the Fed’s large-scale monetary policy (to include rate cuts and “Quantitative Easing” ) will eventually lead to widespread inflationary pressures across the economy. Others say that forcing investors into risky assets could lead to asset bubbles the likes of which we are very familiar with by now. At the very least, we think the Fed is creating a problem of “moral hazard” which may be difficult to unwind in the future.

Old, anachronistic investors believed that they could, under certain circumstances, lose all of their money when making an investment. But the notion of “caveat emptor” seems to have been lost as the Federal Reserve, Treasury Department, and Congress joined forces to save the financial system. Investors learned that the stock market was far too important to the consumer psyche to let it fall too far. Investors also learned that many companies, and therefore investments in those companies, were simply “too big to fail”.

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Like trauma victims, investors also learned of the mind-altering pain relief that comes from the morphine drip ofTARP and Quantitative Easing. Investors changed their views about risk and about what creates value. The term “moral hazard” became a part of our everyday parlance. While there is no way to determine how much of the asset appreciation we have seen since the financial crisis is due to moral hazard, we think it is definitely a factor. Investors know that big brother is there to bail them out if things go too horribly wrong.

Risk has been diminished by readily available government cash infusions. Investors who once relied on fundamentals to make investment decisions shifted focus to forecasting the next intoxicating hit of government dinero. This new, derailed focus on and anticipation of government support may be the most insidious consequence of the last three years. While it may have been seeded under the Greenspan Fed, it blossomed under Mr. Bernanke. At some point, however, this must stop. As long as market participants continue to depend on every utterance from central bankers and government policy makers, dramatic volatility will continue and long-term advances will be unsustainable. The best hope for 2012 is that this paradigm changes and reverts to the long-standing dependence on fundamentals. But we should be careful what we wish for. Ripping off the band-aid could be painful.

Forty countries will hold elections in 2012. This suggests that government officials will take the Machiavellian shortcut of “spend-to-get-elected” politics. While 2012 may feel good for investors as substantial amounts of government funds continue to slosh, the longer term consequences grow increasingly worrisome. The bill is coming due, and governments worldwide cannot simply throw money at their economies much longer.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.