Note to The Fed: Please Stop Helping Us!

Last week as I sat waiting for yet another statement release from a small, unelected group of people who exert incredible influence over the financial markets, there was one thing I wanted to say to them:

Please stop helping us!

If I could send them a note, it would read like this:

       The best arbitrator of interest rates and the price of money is the free market. Not you.

       Your assistance, while well-intentioned, is merely mucking up the works and distorting prices.

       Your actions are killing responsible savers, while rewarding marginal buyers with cheap funds.

       You might be trying to help, but your efforts only complicate matters further.

There is precedence in the Fed’s own history for closing down an interventionist policy, and it didn’t cause the end of the world as we know it.  To find it, all you have to do is search the term: “Treasury Federal Reserve Accord, 1951.”

In the mid-1930s, President Roosevelt had a problem. Upon entering office he initiated massive federal spending programs, trying to spark inflation and motivate people to spend.

Only, it didn’t work out very well. Inflation came, as higher prices and interest rates showed, but the economy didn’t recover as anticipated.

That put Roosevelt in a pickle. He needed to keep selling U.S. Treasury bonds to finance his programs, but rising interest rates were scaring away buyers. So, he enlisted the help of the Federal Reserve.

To ease concerns about falling bond values as interest rates rose, the Fed agreed to buy any long U.S. Treasury bond at a yield of 2.5%. This allowed the government to sell any amount of bonds they wanted — and investors to buy them — without fear of the bonds suffering a loss due to higher rates.

If inflation rose above 2.5%, investors could just sell their bonds to the Fed. If inflation fell below 2.5%, then investors made money. It was a win-win! Sort of. There’s always a downside.

Whenever something is “pegged,” it means other things must be flexible.

When the Fed pegged interest rates, it did so at the expense of the dollar. By purchasing bonds from investors when inflation soared above 2.5%, the Fed flooded the economy with dollars, which created inflation.

Treasury and Fed officials alike thought the trade-off was worth it, especially as the world approached and then went through WWII. But the program continued long after the war ended.

No one could figure out how to stop the program without creating some incredible financial disaster.

Treasury officials worried investors who had lost value on their bonds would storm the government. Fed officials were concerned they needed to be free from the Treasury to restore confidence in the U.S. monetary system. It all came to a head in the early days of 1951.

As the U.S. “police action” in Korea intensified, Fed officials and President Truman jousted over the future of monetary policy. Fed Chairman Thomas McCabe was forced to resign, and Truman replaced him with a Treasury insider, Assistant Treasury Secretary William McChesney Martin, whom he thought would keep supporting U.S. Treasury programs.

He was mistaken.

After he took office, Martin led the Fed on the path to independence, allowing the markets to determine long-term interest rates and bond prices.

The result was… stability.

Without the heavy hand of the Fed, interest rates were free to find equilibrium.  Investors earned higher returns, while borrowers — including the government — had to determine if future borrowing was worth the real cost of funds.

Contrary to many forecasts, the world didn’t fall apart in 1951 as Fed intervention came to an end. The world won’t fall apart today, either. We would be much better off in a financial world without central bank interference. This lesson from history shows that you can’t hold one piece of the economic equation steady at the expense of others.

As for the events surrounding the Treasury Federal Reserve Accord of 1951, there was one negative consequence: Truman was livid.

He felt Martin had betrayed him by severing the Fed from the Treasury, instead of maintaining his loyalty to the Treasury Department. Years later, in a chance meeting on the street, Former President Truman looked at Martin and uttered one word: “Traitor.”

History proved Truman wrong, showing that the economy was much more resilient than he and others thought. It could handle an independent interest rate and bond market back then, and we could sure use one today.

Rodney

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Categories: Banking

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.