Sunday, March 30, 2008

Should the Fed's Mandate Change?

Before I discuss the Fed I wanted to share a chart I picked up from Barron's. I was talking about "selling on the rallies" Friday as we enter a bear market. The chart above illustrates that since Jan. this has been a smart strategy. During bear market rallies, people tend to sell at a certain level because they are not confident that the market will be moving higher. This level now seems to be 12,750.

The Fed:

I wanted to share a great commentary by Bill Fleckenstein . Bill recently wrote a book on Greenspan and has great insight on how damaging the Fed and its "bubble policies" can be to our economy.

I thought his take on Bear Stearns was very insightful:

"However, the important yet subtle point in the current saga is that the "system" has devolved to the point where Bear Stearns, teetering on the edge of bankruptcy, was in effect able to tell the Fed: You can't hurt us anymore, but we can hurt you if the deal collapses, so we demand more money. (Which Bear got a week ago, when JPMorgan Chase (JPM, news, msgs) raised its takeover bid.) Meanwhile, the bondholders (lenders) were made whole -- as the Fed, through its assumption of debt, coughed up roughly $250 per BSC share."

I thought this was a great take on the Bear Stearns debacle. This explains why the offer by JP Morgan was raised to $10 a share. More from Fleckie:

"Under the current Fed chairman, the central bank's modus operandi has changed. Not only has the Bernanke Fed strayed far from its long history of supplying liquidity to just AAA government credits, but, via JPMorgan, it is basically setting up an LLC (a limited-liability corporation, similar to a special-purpose investment vehicle) to hold the dreck that almost ruined Bear Stearns.
It's a structure similar to the off-balance-sheet financial instruments that caused so much pain for so many other financial institutions in the first place.

Sadly, as my friend Jim Grant put it to me recently, the speculators have gained control at the expense of the savers. It's a variation of what I said last week: that the prudent are bailing out the reckless. The Fed seems under the impression that its role is to act as enabler-in-chief. As such, the Fed is an abomination."

My take:

The Fed is clearly setting a dangerous precedent. The Fed was not designed to act as an enabler by bailing out reckless behaviour. They are becoming reckless themselves by trying to save everyone.

They do not have the money to do this. Their reserves are $800 billion and half of this has already been deployed getting us out of this crisis. This behaviour increases the risk of the Fed being forced to inflate out of this mess by printing more money thus leaving our dollar worthless. This would be the only way the Fed could continue this policy IMO.

If we inflate out of this then be prepared to pay $20 for a loaf of bread. The Fed down the road would then be forced to raise interest rates up to 15% or so to stop the inflation which would destroy the value of all assets like housing. This is the worst case scenario. The Fed is now at a tipping point where they need to decide if they are going to let the financials that made mistakes fail or print more money and inflate out of this. Lets hope that they make the prudent decision and allow the speculators to fail. The bubbles need to stop.

As Fleckie explains:

"A good start to preventing future bubbles would be to abolish the Fed. Or, at a minimum, to clarify its mandate. The Fed's No. 1 goal should be price stability, and it should be forced to stop its practice of interest-rate targeting. That is the flawed policy that got us to here.

But until the economy gets bad enough to force such a change, anyone with an ounce of common sense and decency will be forced to endure being routinely nauseated, at the very least."

Its obvious the Fed needs a complete overhaul. Hopefully this will happen before we have a systemic failure.

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