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Why traders are wrong about the Fed

I was at a party with a lot of Wall Street traders last week – in the middle of all the stock-market volatility. And, while the party was quite enjoyable, the mood of several attendees was quite sour — they were certain that a massive selloff had just begun.

Tune in to CNBC's "Power Lunch" on Tuesday, July 15 at 1pm ET. Ron Insana will be on to talk about why traders are wrong about the Fed.

Janet Yellen, chair of the Federal Reserve, speaks at The Economic Club of New York on April 16, 2014.
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Janet Yellen, chair of the Federal Reserve, speaks at The Economic Club of New York on April 16, 2014.

As has been the case over the last several years, I found myself having more than one conversation in which my counterpart was insisting that Federal Reserve policy is certain to lead to a disastrous outcome for the economy and markets. Two were quite insistent that our days are, indeed, numbered.

I asked a few of them to explain why such a fate is certain.

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They said that a zero interest-rate policy (ZIRP) and quantitative easing had never been tried before and therefore must end badly. How could they not?, they insisted. No one knows what these policies will bring. A stock-market crash, hyper-inflation and a collapse in the dollar were all listed ascertain outcomes of the Fed's "irresponsible" actions.

The fault in their stars was obvious to me. If no one, including the Fed, knows what zero interest rates and a bulging Fed balance sheet will do to the economy, then how can they?

Of course, one could argue that my own position relies on the same faulty logic, that I don't know any better than anyone else as to how this will end.

However, I have spent a considerable amount of time studying the documentary evidence, used by the Fed, to support the necessity, and efficacy, of the policy tools that saved us from a near-certain depression. Unlike many others, I see great hope, and considerable evidence, that the Fed knows exactly what it is doing and has a clear, and well-designed, plan to unwind the program once it is satisfied the desired results have been achieved.

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My party counterparts, insisted I was wrong, declaring again, that the results HAD to be calamitous.

One partygoer insisted that my point of view was entirely wrong. I don't mind that, but I was instantly reminded of a question that hedge-fund investor, Michael Steinhardt, used to ask his traders when seeking justification for a proposed investment idea: "What do you know that the rest of the world doesn't?"

The fact is, the very critics of the Fed, who claim the Fed doesn't know what it's doing, haven't even the foggiest idea of why the Fed might be wrong!

"It's all artificial!" They say. "The market is on a sugar -- or crack – high! How can they exit without destroying the world?"

All questions … no answers.

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Oddly, very few critics of the Fed's policies have ever deigned to read the voluminous amounts of data on the subject of ZIRP or QE.

And, while even the Fed admits there are a vast number of uncertainties about potential outcomes, there is also a fair amount of empirical data which points to a more favorable result that anyone can, or will, acknowledge.

In a 2004, then Fed governor, Ben Bernanke, colleague, Vince Reinhardt, and economist Brian Sack, co-authored a paper discussing the empirical evidence that showed how certain aspects of unconventional monetary policies have worked in the real world.

"Whether hitting the ZLB (Zero Limit Bound) presents a minor annoyance or a major risk for monetary policy depends on the effectiveness of the policy alternatives available when prices are declining. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes: (1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank's balance sheet; and (3) changing the composition of the central bank's balance sheet. We discuss how these policies might work and cite existing evidence on their utility from historical episodes and recent empirical research."1

One can see that the policies used by the Fed in recent years were fully articulated in white papers that virtually none of the Fed's critics have ever read!

This is only one example of the pre-emptive work the Fed initiated to support the use of unconventional monetary policies if, and when, needed.

Many papers go even further back in time, testimony to the deep research and study undertaken by those who would eventually be forced to use the very policies that have mitigated the effects of the worst crisis seen in America since the Depression.

Indeed, the Fed began researching how to employ non-standard tools years before the crisis hit, and examined, very closely, the risks, and rewards, of potential actions taken when interest rates are reduced to zero.

By the way, there are also plenty of empirical data which illustrate how a failure to employ such measures deepened the Great Depression in the 1930s, and severely prolonged the recession and deflation that gripped Japan since the early 1990s.

The failure to act, rather predictably, had far worse outcomes than those we have experienced in the wake of the Fed's unprecedented actions. And yet, no one has given the Fed credit for carefully planning and executing strategies that have successfully aided the economy's recovery, lifting asset prices and preventing deflation from setting in.

I think there is considerably less risk in the markets and economy than the bears would suggest.

I remain steadfast in the belief that the Federal Reserve under Ben Bernanke, and now Janet Yellen, has done extraordinary research to support the polices being employed today.

I am equally certain that those who oppose the Fed's actions, or believe they will lead to yet another doomsday scenario, haven't begun to scratch the surface of readily available research that might change their minds.

So, I ask the Fed critics: "What do you know that the rest of the world doesn't?"

Commentary by Ron Insana, a CNBC and MSNBC contributor and the author of four books on Wall Street. He also delivers a daily podcast, "Insana Insights," and a long-form weekly version, both available on iTunes and at roninsana.com. Follow him on Twitter @rinsana.

Footnote:
1. Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack 2004-48

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