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Don’t Fight the Fed

Stock-Markets / Financial Markets 2010 Nov 06, 2010 - 04:56 AM GMT

By: Joseph_Toronto


Does this rule still really apply?
Comparisons of economic conditions of today with those of the Great Depression abound, as well as comparisons with Japan’s “lost decades”, most implying that we are doomed to a repeat of those woeful eras. We know of course that the Fed did everything wrong in the 30′s and made things worse. Beginning in 1990, the Bank of Japan did everything right but it did no good. Why would this time around be any different?

I wrote previously about the phenomenon known as the liquidity trap, a condition that renders the monetary policy levers of the Fed impotent, leaving the Fed to try to push on a string. As Paul Kasriel of Northern Trust noted,

Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the great depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently in the 1990′s, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.

The mistakes the Fed made in the 30′s were that it let too many banks fail thereby vaporizing peoples savings, collapsing the money supply, and which drastically reduced the number of lending spigots (shuttered banks).

So what monetary policies are in place today that may lead to a different result?

  • There are not massive bank failures. The lending spigots all remain available and in place although maybe not being put to use at present.
  • People’s savings are not being vaporized. On the contrary, FDIC insurance is in place, it’s limits recently have been doubled, and the Fed is proactively now insuring money market funds which don’t carry FDIC insurance.
  • Although the 30′s Fed drastically reduced interest rates, the bank failures and the liquidity trap rendered the ZIRP policy generally fruitless. The Fed was also held hostage by the gold standard which forced the Fed to actually raise rates in 1931 to stem the outflow of gold. Countries which abandoned the gold standard earlier, emerged from depression earlier. There is no gold standard today. The Fed can print money at will and is threatening to do exactly that by monetizing federal debt with outright Treasury bond purchases.
  • In 1930, Congress eviscerated the Feds monetary efforts with protectionist legislation (Smoot-Hawley tariffs). Such trade protectionism is virtually absent in today’s free trade climate.
  • In the 1930′s Congress further complicated monetary policy with the false perception that fiscal responsibility would improve the economy and raised taxes. Tax cuts and massive deficit spending are the order of the day today.

Having said all of that, is it safe to get in the pool again with the Feed’s massive easing policies in place?  Believe it or not, there actually is good credit out there, backed by good assets, that is seeking good borrowers. They will eventually meet up.

Finally, the clincher. When the Congress finally finds its will to act with some form of misguided legislation, it’s usually too little or too much, too late and a recovery is usually already underway. Just remember that most economic data coming out now, the same stuff that Congress and the Administration watch such as employment and/or unemployment, is lagging data. The banking system will continue to unfreeze and the economy will recover as the Fed and Congress plan to provide overkill.

Bottom line: “DON”T FIGHT THE FED.” Do so only at your own risk.

Very Best Regards,

Joseph Toronto

Affiliated Investment Advisors, Inc.

Joseph Toronto has been a portfolio manager for 26 years for some of the largest institutions in the western U.S. In 1993, Joe founded Affiliated Investment Advisors, Inc., as a registered investment advisor for serious investors seeking professional management for superior safety and returns. Mr. Toronto is a Chartered Financial Analyst and is a member of the Salt Lake City Chapter of the Financial Analysts Society and the Association for Investment Management and Research. He has a Master's degree in investment securities and a B.A. degree with a dual major in finance and management.

© 2010 Copyright Joseph Toronto - All Rights Reserved

Affiliated Investment Advisors, Inc. is a "traditional" portfolio manager for retirement plans, profit sharing plans, individuals, IRA's and other trusts. Affiliated’s portfolio management services are NOT alternative "hedge" fund style and are “fee only” taking no commissions or performance incentives. Affiliated is not a stock broker or financial planner and does not sell any investment or insurance fund or product.

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