Bondholder Alert: Disconcerting News from the Federal Reserve

Wednesday, October 13, 2010

Fed Vice Chair states the obvious. Two lessons learned:

  1. Easy money can lead to leverage and speculation
  2. Markets cannot be counted on to self-correct

Wow! That reaction is not for the lessons. It’s for the admission that the Fed had to relearn them. US financial history is filled with examples. Indeed, the Federal Reserve was created because of repeated financial “panics” and their adverse effects.

So, what else do they not know?

One item, based on comments in the article below, is that the Fed’s actions cannot produce growth and create employment. Been there, tried that (Congress’ 1978 Humphrey–Hawkins Full Employment Act). The result was inflation without growth or jobs (“stagflation”).

The Fed board members don’t even have to read a book to learn the lesson. They just have to invite previous Fed Chair Paul Volcker to talk to them – he had to clean up the aftermath in the early 1980s. But then, Fed Chair Ben Bernanke wants to do it his way and even now is talking up the desirability of boosting inflation.

Dr. Jekyll’s inflation cure works until it turns into Mr. Hyde’s inflation illness

These revelations of ignorance come just when the markets supposedly are counting on the Fed to engage in more “quantitative easing” (AKA printing money). But then, Wall Street loves easy money – as does Congress, businesses, banks, employees, consumers, borrowers and non-bond investors (even bond traders welcome the volatility inflation brings). And now bondholders have lost their Fed friends – a stunning development by the independent government agency responsible for ensuring the US monetary system remains sound.

So… If you haven’t already, it’s time to question the wisdom of owning bonds. If Bernanke is “successful” in ramping up inflation, interest rates will rise (purchasers demand a “real” return) and bond prices will fall. Hmmm… Think that’s another lesson the Fed needs to learn?

Fed’s Yellen: Possible that low rates feed bubbles” (Reuters, by Ann Saphir, October 11)

“’It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system,’ [Federal Reserve Vice Chair Janet] Yellen said in prepared remarks to the National Association for Business Economics.”

“’(Financial markets) were viewed as self-correcting systems that tended to return to a stable equilibrium before they could inflict widespread damage on the real economy.’”

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John Tobey on Seeking Alpha

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October 2010