An Ill-Conceived Attack on Fed Powers

November 13, 2009 Edition, Volume III

Inside Signature Update

- The Market - Expectations for Steady, Though Modest, Growth
- The Economy I – Get Ready for the VAT – Value-Added Tax
- The Economy II – An Ill-Conceived Attack on Fed Powers
- The Takeaway – Higher Equity Values and Tax Rates



THE MARKET – Expectations for Steady, Though Modest, Growth

The continued rally in the US equities market is simply a reflection of a weakening dollar, low interest rates, moderated inflation pressures, and earnings growth in most market sectors. With widely reported corporate earnings growth and 3.5% GDP expansion for the 3rd Quarter, as well as promising retail sales reports, the DOW stands firmly above the 10,200 level. Most market analysts, traders and investors expect relatively steady, though modest improvement in the markets as we move into 2010.

Likewise, gold has continued its rally, and while there may still be room for gold to appreciate above these levels, especially in the face of a weak US dollar, most prudent investors are nervous at what has all of the earmarks of a bubble in the precious metals market.

Oil’s upward movement towards the $80 per barrel level is more fundamentally supported by increases in demand, but has also enjoyed the weaker dollar. When the Fed finally moves to increase interest rates and strengthen the dollar, precious metals and oil will give up their exchange related gains. These commodities are ripe for speculation at these levels and ought not to be considered as long-term investment assets.

For months we’ve suggested that this rebound is far from over and evidence continues to mount suggesting that a recovery, both in the economy and the stock market, has plenty of room for continued expansion – and profits.


THE ECONOMY I - Get Ready for the VAT - Value Added Tax

Both the Obama administration and House and Senate Democrats have vowed to increase taxes on high income Americans while providing tax cuts for the middle class and bringing yet more relief for lower income earners. While this may make for great campaign rhetoric, it’s not at all likely. Not only have the administration and legislators introduced bills which would expand federal budgets by trillions of dollars for many years to come, they’ve begun to talk about a new kind of tax with which most Americans are unfamiliar.

House Speaker Pelosi confirmed plans to introduce a value-added tax in an effort to offset the rising costs associated with federal spending plans, saying ‘somewhere along the way, a value-added tax plays into this’.

Those who’ve traveled through Europe may be familiar with the VAT tax, or value- added tax. VAT is a form of national sales tax and now ranges between 17% and 25% in most European countries. Introduced as an alternative to income taxes, it quickly became a companion to personal and business income tax and represents much of the increase in taxation experienced throughout Western Europe in the last 50 years.

Simply put, the value added tax is a tax levied on most business transactions and on most goods and services. Though policy makers may discuss it in terms of taxing higher consumption families more aggressively than those with less discretionary incomes, the VAT tax raises the cost of virtually everything in a marketplace, regardless of one’s income level. Even if a tax credit is applied to help offset value-added tax payments made by lower income Americans, it will be virtually impossible to mitigate the impact of the rising cost of goods and services associated with VAT throughout the production and manufacturing process.

President George H.W. Bush’s infamous phrase, ‘read my lips, no new taxes’, used first in the 1988 New Hampshire primary and then most famously in his acceptance speech at the Republican Party National Convention in New Orleans that same year, came back to haunt him and helped Clinton unseat the once-popular President. One has to wonder how often President Obama replays that scenario in his mind as he considers just how difficult his re-election bid may become.



THE ECONOMY II - An Ill-Conceived Attack on Federal Reserve Powers

Senate Banking Committee Chairman Chris Dodd (D-CT) announced Tuesday plans to curtail the powers of the Federal Reserve and the FDIC in a sweeping piece of legislation promising to reform banking and avoid future crises. Dodd cited the ‘abysmal failure’ of the Fed’s role as banking regulator and moved to create a new regulator, the Financial Institutions Regulatory Administration (FIRA). Fortunately the legislation faces nearly as many challenges as the ill-fated health care bill recently passed by the House of Representatives; it hasn’t sufficient support to make it out of the Senate.

Dodd, like most bureaucrats, believes the best solution to a bureaucratic challenge is another layer of bureaucracy. This latest proposal shows how little he and his committee understand about how close we came to financial calamity before then Treasury Secretary Paulson and Fed Chairman Bernanke used the Fed’s considerable powers to avert disaster. Certainly, Bernanke and company had a hand in creating the crisis, as did many others; including Dodd and his party’s leadership. To attempt to limit the problem solving ability of the central bank is more dangerous than most might suppose.

Treasury Secretary Timothy Geithner and House Financial Services Committee Chair Barney Frank laid some of the groundwork for Dodd’s proposal in late October as they discussed the need to reform and bring oversight to the financial markets. Though the outward intent of proposed reforms appears reasonable in light of recent events, they expose policy makers’ interest in gaining influence over the Federal Reserve and FDIC.

While the FDIC may arguably be fair game, it is critical that the Federal Reserve remain as independent as possible in order to maintain the relationship of trust it enjoys in the financial markets and with central bankers around the world. A Federal Reserve overseen by a politically organized federal agency would yield a weaker US dollar and impotence while striving to maintain modest inflationary pressures and domestically advantageous exchange rates. Without its full range of powers the Fed simply cannot affect is primary mission.

FDIC Chairwoman Sheila Bair sharply criticized the proposal and added ‘The oversight council described in the proposal currently lacks sufficient authority to effectively address systemic risks.’ Though some level of regulation in response to the financial crisis through which we have now lived for more than a year is inevitable and even necessary, the current administration’s direction, as proposed by some of its most loyal operatives, is simply counterproductive, perhaps even power-seeking. What we need are objective and progressive reserve requirements to aid in preserving liquidity for banks operating in the capital markets, and a regulatory structure long on accountability and short on political motives.

The current rhetoric appears as ill-conceived as was the Graham-Leach-Bliley Act’s 1999 repeal of Glass-Steagall without structuring capital market requirements for those banks playing both sides of the market. In its current form, the proposal could weaken policy makers’ authority to get us out of the turmoil it may well get us into in the future.



THE TAKEAWAY – Higher Equity Values and Tax Rates

Investors sitting in cash or other fixed instruments may have already missed the largest part of the current market recovery, but modest, steady growth in equities appears likely through 2010. This is not a time to stay on the sidelines.

It’s virtually impossible for tax rates to rest at current levels, well enough improve, given the planned level of spending. The revenue to be garnered by taxing only the highest income earners isn’t enough to pay the bill. Tax rates for all but the lowest income levels are likely to increase, starting with the sun-setting of major portions of the Bush tax cuts in 2011.

Democratic leadership in the House and Senate are frustrated at their inability to pass major legislative initiatives as members of their own party thwart a too-liberal agenda. One needn’t be ultra conservative to see the flaws in their reasoning.






Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC