American Investment Services, Inc.

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Nov. 2010 – The Fed’s Mission Implausible

The Federal Reserve’s Board of Governors announced on November 3 that it would purchase another $600 billion in Treasuries in order to reduce long term interest rates. In response long term rates began to increase immediately. As the month drew to a close the 30 year Treasury bond yield had increased from 3.93 percent to 4.25 percent.

It remains to be seen whether the central bank, ultimately, will achieve its goal, but this perverse reaction from the market speaks to the Fed’s overwhelming, if not impossible, challenge. Not only is its mandate unrealistic, the Fed also confronts unprecedented government spending and borrowing that threaten to overwhelm its policy tools.

In 1978, Congress required that the Fed’s Board of Governors and the Federal Open Market Committee seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” These objectives are inherently conflicted. When the Fed attempts to spur employment through monetary stimulus — by expanding the money supply — it invariably invites price inflation in the long term. The bond market, moreover, does not wait around for prices to rise — it is the expectation of higher prices that prompts lenders to demand that today’s long term interest rates include an adequate inflation premium.

The Fed’s ambitious monetary expansion has endured withering criticism from pundits and politicians here and abroad. In our view there is little to be gained from either criticizing or defending the particular decisions of the current Fed, or debating the competence of its Board of Governors. These circumstances arise from the fundamental flaw that is formalized in the Fed’s stated mission.

Now that it is fashionable to beat up on the Fed, Congress smells blood. Criticism now emanates from both houses — never mind that it is Congressional fiscal profligacy that is at the heart of the current predicament. Federal spending is expected to reach 26 percent of GDP this year, a peacetime record. Debt monetization and resulting price inflation have long been the refuge of fiat-currency governments seeking to avoid explicit default on their sovereign debt. As if the dual mandate was not challenging enough, Congress has further clouded prospects for price stability.

Increased uncertainty discourages risk taking, with both savings and capital formation suffering. Additionally, prices distorted through monetary inflating are less reliable as signals for the efficient allocation of resources. That said, we will continue to search out those asset classes best suited to providing positive, and stable, real returns for your portfolio.

Also in This Issue:

Tax Swapping Time
Passive Investing: Tailor Made for Tax Swapping
Insider Trading and the Passive Investor
Owning Physical Gold
The High-Yield Dow Investment Strategy
Who is an Insider?
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles