How the Fed Will Wean America From Cheap Money

June 18, 2013 — -- One of the main reasons for the soaring stock market is the current low cost of capital for public companies. This cost is far lower than it otherwise would be because of a program undertaken by the Federal Reserve Board (the Fed) that goes by the nerdy name, quantitative easing, or, for short, QE.

Essentially, QE (not to be confused with the ocean liner) is the Fed's effort to boost the slow-growing economy by buying about $85 billion in existing bonds from banks every month. It's a form of stimulus, but unlike the earlier rounds of stimulus, the government is lending money with interest attached instead of giving it away or spending it.

Injecting all this money into the economy is keeping many interest rates artificially low. The stock market loves this because lower rates mean more available cash. (Of course, at the same time, the government is committing billions in tax dollars to these loans to stimulate the economy, the sequester cutbacks are reducing stimulus that already existed.)

QE introduces stimulus because its effects on interest rates lower the overall cost of capital, indirectly encouraging more risk-taking and investment in general. All of this helps companies improve earnings, which prompts people to invest.

Whenever anyone on the Fed's board says anything interpreted as less than eternally committed to sustaining QE, the stock market wretches. That's because the market is addicted to this continuous infusion of cash. Other nations in the troubled global economy are doing the same thing. Yet, since such concurrent policy moves by multiple global economic powers is unprecedented, it's hard to say for certain just what will eventually come of it.

Here in the U.S., one thing is clear: The market is so accustomed to stimulus from QE that it is poised to retrench if it is cut off. And it is unduly fearful that the Fed would be short-sighted enough to suddenly turn off the spigot.

The market is such an extreme QE junkie that, perversely, whenever there's talk about the economy improving, stocks go down. Clearly, the market is afraid that the Fed would be cruel enough to put it on cold turkey.

Investors who react this way aren't thinking about a sound economy in which QE wouldn't be needed any more than a heroin addict thinks in terms of life without a fix.

The Fed must decide when and how much to cut back on QE as the economy improves. It faces the challenge of making decisions that have real reactions because of the perverse market psychology – viewing economic recovery is undesirable (at least in the short term) because it would mean less stimulus – that QE policy has created as an unintended consequence.

But the Fed's job isn't to second-guess the financial markets. Instead, its role is to tweak key, controllable aspects of the economy to maintain and improve it as a whole. Part of this involves sending the right signals to the stock market – not by marching to the beat of paranoid investors. Most likely, we will eventually see a Fed treatment plan to wean the economy off stimulus. – a sort of fiscal methadone. This might involve slowly tapering off the bond-buying by reducing it a few less billion each quarter – a move recommended by Alan Greenspan, who was Fed chairman under a few presidents.

Such a move would have to be well-timed to provide the right balance between support and allowing the economy to improve on its own. This policy would have to take into account actions of Congress regarding government spending (or not spending, a la sequester) because federal spending accounts for about 30 percent of the U.S. economy. This policy would also have to take into account the combined effects of the QE of other nations.

While big institutional market movers worry about what the Fed might do next regarding QE, you're probably wondering whether you should be worrying, too. The answer to this is yes – insofar as the overall direction of the market affects your returns – and no, insofar as your investment goals should be different than those of big institutional traders who search for hidden meaning in every ambiguous public utterance by a Fed board member.

While following the continuing QE saga in the headlines, here are some things to keep in mind:

• As the market goes up and down over anticipated QE changes, ignore these short-term gyrations and keep your eyes on the prize of long-term net returns. To the same extent that less QE sends the market downward, real economic recovery will eventually bring it up again.

• Expect the Fed to get it right. Sure, there's distrust aplenty in the government these days, but weaning the economy off QE without lasting harm is clearly doable because you can see results as you go along; this is not critical one-time surgery but a gradual treatment. If things go awry from cutting stimulus back too quickly, the Fed can always restore some degree of stimulus. The key will be to watch the scales go up and down to find the tipping point.

• There will be pain along the way, but this doesn't have to be your pain. Rise above the herky-jerky, cash-in-big-today market mentality by sitting back and benefiting from QE today and from real economic recovery down the road.

After all, if you don't believe that the economy will improve sustainably, rendering QE unnecessary, then what are you doing in the markets in the first place?

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a certified financial planner, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the adviser to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on how to achieve their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.