A bad sign for the Fed as we know it

Submitted By Tim Iacono
Someday, future historians may write the following:

During the entire era of the Federal Reserve, a system that abruptly ended almost exactly 100 years after it began in 1913, the central bank directly controlled short-term interest rates.

This, effectively, determined the rate of interest that banks paid for money market accounts and other short-term savings and, when the economy entered a recession, it was standard Federal Reserve policy to slash interest rates, compelling savers and investors to move their money from safe, low-yielding accounts to riskier assets with the potential for higher returns.

Up until the stock market crash of 2008, this proved to be an effective way to boost an ailing economy, however, it had the unpleasant side-effect of producing ever-larger asset bubbles that repeatedly burst.

After the 2008 crash, fewer and fewer investors and savers opted to seek higher returns by taking on more risk and this proved to be a major factor in the American economy experiencing years of...

Without revealing exactly what kind of future historians may someday be writing about in regards to the U.S. economy, you should get the idea here.

It seems that the Federal Reserve may now be "going to the well" once too often with short-term lending rates now sitting at zero percent and banks paying virtually the same for savings. The problem is, people are taking their money out of low yielding accounts but it's not being used to bid up prices to help inflate another asset bubble.

This story in USA Today provides all the details:

Investors are yanking money out of money funds and moving to bond funds — but some are just cashing out.

Investors pulled a net $490 billion from money funds this year through October, according to the Investment Company Institute, the funds' trade group. A record-shattering $313 billion went to bond funds. And $1.9 billion fled stock funds.

"More money is flowing out of money funds than is going into bond funds — something that's only happened twice in 26 years," says Vincent Deluard, strategist at TrimTabs.com, which tracks fund flows. "It shows how deep the recession is: They may be taking money out to pay the bills or the mortgage."

Normally, investors chase after stocks during periods of red-hot returns, and this year has produced rip-snorting returns for many stock funds. The average stock fund has soared 27.4% this year, according to Lipper, which tracks the funds. And 36 funds have soared 100% or more in 2009, led by the tiny Oceanstone fund, up 260%.

But investors aren't chasing hot returns. And since the end of October, money fund assets have fallen an estimated $176 billion, the ICI says. An estimated $9.4 billion has fled stock funds. And $50 billion has poured into bond funds.