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History Will Condemn the Fed's Actions

NEW YORK ( TheStreet) -- If the U.S. economy is a sick patient, the Fed's intervention acts more like leprosy than medicine.

Our economy is no doubt suffering from multiple wounds, but a numbness prevents us from fully understanding the severity of our injuries. That numbness is the policy of the Federal Reserve -- designed to protect us from horrifying economic realities -- but preordained to fail.
Federal Building

The road to hell is paved with good intentions, and U.S. monetary policy might carry ramifications that will further threaten our economic system. Here are the biggest risks:

Potential to Disrupt Money Market Funds

The Federal Reserve's zero interest rate policy (ZIRP) -- an extended pledge to keep the federal funds rate at 0% -- is not without consequences. One potential result: Money market fund managers will overreach for yield by investing in riskier debt instruments.

It's important to realize that investors psychologically regard money market funds as cash ( despite their lack of FDIC insurance). If these funds suffer losses and "break the buck," meaning that the share value falls below its fixed target price of $1, a bank-run like panic might ensue.

Putting U.S. Pension System in Jeopardy

In addition to putting money market funds at risk, zero interest rate policy might have damning consequences for pension funds (both public and private). The financial viability of a pension fund is determined by its anticipated vs. actual rate of return. In the 1980s, funds could anticipate a 10% return without breaking a sweat: It was possible to purchase Treasury bonds yielding that or better.

Now, with the risk-free rate scraping against all-time lows, things aren't so easy. Monetary policy will likely push pension funds into risk assets, such as stocks. But as these funds grow dependent on the stock market for generating returns, so too grows the necessity for the Fed to support asset prices. This is a vicious circle -- and a dangerous one.

Enabling U.S. Companies to Hoard Cash Overseas

By keeping interest rates of benchmark U.S. government debt artificially low, the Federal Reserve is gifting many companies with cheap money, and subsequently, tax deferment.

Google -- a company that has nearly $35 billion in cash and equivalents -- recently raised $3 billion in debt at a bargain 1.25% yield. Same story with Microsoft.

Cash-rich companies are raising cheap money domestically while they keep hoards of cash overseas. The longer this money is kept overseas, the greater the likelihood that U.S. politicians will foolishly agree to a second 'one-time' tax holiday -- a disaster for employees and U.S. tax receipts, but a windfall for corporate managers.

Fueling a U.S. Human Capital Bubble

The financial industry will continue to poach America's brightest minds as long as it can offer the largest salaries. And as long as the financial system is artificially supported by the government and the Fed, we withhold human capital from migrating to more productive areas of the economy.

That's the libertarian's argument against bailouts, and there's truth to it.

Ultimately, it's not the size of the U.S. financial industry that's disturbing -- rather, the nature of it. When an engineering graduate is hired to develop an inverse-leveraged ETF with daily resets (mathematically guaranteed to lose value in volatile markets), the economy does not benefit.

America's brightest-young minds are being recruited to develop casino games. But the real sin is the opportunity cost: Somewhere, a great engineer nearing retirement should be teaching a protégé, not fretting over the viability of his or her pension.

-- Written by John DeFeo in New York City


QE3 Guaranteed to Fail >>
The Federal Reserve is ignoring the historical failures of quantitative easing.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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