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Is the Fed Endangering the Financial System?

Is the Fed Endangering the Financial System?  
Ron DeLegge, Editor
September 27, 2011 

Will the Federal Reserve’s latest plan to shuffle its trillion dollar bond portfolio help the economy to get back on track? Or is it, as they say in football, just another Hail Mary pass?


Operation Twist
The Fed’s announcement last week said it would shift around $400 billion from short-term debt (NYSEArca: SHY) into longer-term U.S. Treasuries with maturities as short as six years (NYSEArca: IEF) to as long as 30 years (NYSEArca: TLT). This plan is not a new idea, but a sequel to something tried in the 1960s.

During the Kennedy Presidency, the original “Operation Twist” amounted to the Fed buying longer term debt and it worked, temporarily. A study by the San Francisco estimated a 0.15% reduction in bond yields. More importantly, the Fed’s original twist caught the market off guard. What about now?

Where’s the Surprise?
If the Fed’s bold moves have been muted, they have no one to blame but themselves. In 2008 they announced a massive mortgage bond buying program (NYSEArca: MBB), giving the market plenty of time to react. This time around, they’ve repeated that same mistake. The market doesn’t just like good news – it likes to be surprised with it.

As with QE1 and QE2, the Fed wants to increase business spending, new investment and to help the housing market (NYSEArca: XHB) to recover. According to them, keeping interest rates low until 2013 is the prescription, but will it work?

If you’re doubting whether the Fed’s monetary trickery will be an effective remedy, you’re not alone. Richard Fisher, President of the Federal Reserve Bank of Dallas, has doubts too. In a speech today, Fisher said Operation Twist was “a strategic decision where I did not feel the benefits outweighed what I perceived to be the costs.” He also added it could increase excessive risk-taking and hurt job creation. Does that sound like a fiscally disciplined Fed to you?

Unintended Consequences
For every beneficiary that benefits from whatever the Fed does, there’s a long list of victims. Savers, once again, will be penalized by the Fed’s actions in the form of depressed yields on bank CDs, savings accounts and money market funds.
On the other hand, borrowers will benefit, but the extension of cheap credit has yet to jumpstart job growth or the broader economy.

The other victims of the Fed’s policies are to-be-announced or TBA. They will most likely be investors who’ve been riding on the coattails of low rates by making risky bets. Unfortunately, this is the type of perilous behavior the Fed has not discouraged.

Is the Fed doing its Job? 
It’s a paradox the Federal Reserve was created in response to the financial panic of 1907. Its policies, which even its own board members, are questioning, should not promote bubbles or meltdowns, but avoid them. The Fed’s principal duties are to maintain stability within the financial system, to supervise and regulate banks, to conduct the nation’s monetary policy and to provide financial services to depository institutions and the U.S. government.  Have they forgotten?

Don’t be fooled by the Federal Reserve’s Website address which contains .gov. Contrary to what many people think, the Federal Reserve is actually a private bank and not a federal agency.  It receives no appropriated funds from Congress. Why is that important? Because it means the Fed, like any corporation, can be forced into dissolution or outright bankruptcy due to poor decisions.

Finally, it’s important to remember the current Fed is actually the third central banking experiment in the U.S. Its predecessors were the First Bank of the United States (1791-1811) and Second Bank of the United States (1816-1836). Put another way, the history of central banks is shaky, which rightly makes us question their future viability.

Conclusion 
The prospect of investing in a world with a severely weakened or impotent Federal Reserve comes as no surprise to ETFguide’s subscribers. It’s a theme we’ve touched on more than once.  In the end, ETFguide’s Profit Strategy ETF Newsletter continues to advocate a fiercely independent view of world events, financial markets and the proper allocation of money. Ultimately, building an investment strategy that can perform during any kind of market climate is a good start.

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