The Fed's oversteering and the wreckage of the past decade

With a strong rally today, the general stock market roared back . . . to a level it originally reached twelve years ago.

Meanwhile, Fed Chairman Ben Bernanke in testimony before Congress earlier this week and in a Wall Street Journal article he published on Tuesday declared "accommodative policies will likely be warranted for an extended period."

As an excellent editorial in the same Wall Street Journal pointed out the next day, "we’ve been here before — specifically, in late 2003 when Mr. Bernanke was a Governor at Alan Greenspan’s Fed. Despite an expansion that was already well under way, Mr. Bernanke argued at the time that the Fed needed to keep the fed funds rate at 1% for an 'extended period' in order to reduce unemployment."

We would argue, and have argued before, that the economic wreckage of the past decade has the fingerprints of Fed over-steering all over it. As the Journal's editorial board point out above, Fed over-steering in 2003 led directly to the housing and mortgage bubble that exploded in 2007 and 2008 (for evidence of that one need look no further than the graph in this blog post).

Fed over-steering was also culpable in the Nasdaq bubble of 1999 which collapsed in 2000-2002, as we explained in "The long shadow of the Y2K bug" and "Revisiting the 'New Economy.'"

In short, the Fed's attempts to both "promote economic recovery and price stability" (as Mr. Bernanke put it in his testimony before Congress this week) has led to widespread and unnecessary economic suffering for countless individuals. By trying to steer the economy and "promote recovery" the Fed creates boom and bust cycles of volatility that are far worse than would be the case if they simply focused on price stability and let businesses create the recovery.

How long will this Fed volatility continue? It appears to be with us for the foreseeable future. Currently, the Fed is in a very accommodative posture and Mr. Bernanke's stated belief in the "output gap" is likely to keep it accommodative long enough to cause inflation and/or another bubble somewhere.

Investors must be acutely aware of this phenomenon, which we believe is responsible for much of the pain they have felt over recent years.

The best response to this oversteering Fed, in our opinion, is to avoid chasing after faddish speculations (such as last year's commodity bubble and currency speculation, both of which we warned against at the time). Instead, investors should build the foundation of their future purchasing power on innovative, growing companies -- the only vehicles that over time have shown the ability to stay ahead of the dangerous swerving Federal Reserve.

For later posts dealing with this same subject, see also:

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