Warren Buffett on the Fed: Great Experiment, Greatest Hedge Fund

Money

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At Georgetown University in Washington on Thursday, Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB) Chairman and CEO Warren Buffett told students that the U.S. Federal Reserve is “the greatest hedge fund in history.” The statement came in response to a question from a student — who called Buffett an “outspoken fan” of current Fed Chairman Ben Bernanke — about whether or not he thinks the Fed will continue its “controversial buyback program.”

The day before this question was asked, the Federal Open Market Committee concluded a two-day policy meeting and surprised markets when it revealed that it would not reduce purchases, and maintain buying $40 billion worth of agency mortgage-backed securities and $45 billion worth of longer-term Treasury securities every month.

Buffett first stated the obvious: the Fed did not change its policy because it did not see the necessary change in economic conditions. Over the past year, the Fed has refined its policy of forward guidance, repeatedly highlighting the various perquisites for a policy change. Chief among the conditions is a real and sustainable improvement in labor market conditions in the context of price stability.

“He says he’s going to keep doing it until he sees more improvement in the economy” Buffett said. “And I think he’s been mildly disappointing — not hugely disappointing but mildly disappointing — in the rate of improvement in the economy over the past few years. He’s not pre-judging exactly when it’s going to happen, he’s telling you the conditions under which he’ll change.”

Just to make sure everything’s on the table, the Fed has been pretty quiet about exactly what conditions would have to look like in order to taper purchases. The health of the labor market can be measured in at least a dozen ways, and right now, the headline rate is particularly misleading. In August, the number of unemployed persons in the U.S. edged down from 11.5 million to 11.3 million, pulling the headline rate of unemployment down from 7.4 to 7.3 percent.

However, not only is long-term unemployment still extraordinarily high (4.3 million people, or 37.9 percent of the unemployed), but the labor force participation rate has come down dramatically since the beginning of the recession, from about 66 percent to 63.2 percent in August.

As it stands, as long as the recovery still seems anemic, the Fed has an economic imperative to keep its foot on the gas. This much has been clear since at least the Fed adopted its policy of forward guidance. But at a glance, it has also been just at clear that the longer quantitative easing lasts, the riskier the Fed’s position becomes. ”We are in an experiment that hasn’t really been tried before,” said Buffett. “The Fed has a $3.5 trillion balance sheet, and is buying and selling securities. We don’t know how this game plays out. If the Fed deleverages in any big way, that will be an experiment.”

Experimentation has been and will continue to be critical for the central bankers of the future. The role of central bankers as stewards of financial conditions expanded enormously in the wake of the financial crisis for this reason: the tools developed in previous decades were inadequate to address the problems of the global financial crisis of the late 2000s. Central bankers were forced to expand their thinking and adopt unconventional tools and strategies in their efforts to avoid total catastrophe.

“When there’s a panic,” said Buffet, “the only thing that will stop it, basically, is when somebody who has the ability and the will says ‘I’m going to do whatever it takes.’ And basically that’s what Bernanke and Paulson did.”

This seems to refer most directly to the bailouts and quantitative easing, which have arguably become the most controversial aspects of the monetary policy championed by Bernanke, but it’s really the entire monetary and financial mechanism that has been distorted. In part, this is why the Fed can be called the greatest hedge fund in history.

A unique set of circumstances not only allowed but compelled policymakers to engage in a strategy that, in 2012, net the federal government $88.4 billion (the Fed remits profits to the Treasury).

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