Fed's worst nightmare: The 'ghost of 1937'

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In trying to steer the economy of 2015, the Federal Reserve is fighting the foreboding spirit of 1937.

Wall Street strategists, in fact, are worried that the U.S. central bank is so cautious over not making the mistakes of a long-ago ancestor that it may miss a solid opportunity to normalize monetary policy after seven years of decidedly abnormal times.

"Many policymakers and market observers assert that the risk of the Fed raising rates too early exceeds that of moving too late. This is the specter of 1937, when the Fed raised rates prematurely and exacerbated the Great Depression," Michael Arone, managing director and chief investment strategist at State Street Global Advisors, said in an analysis for clients titled "Why the Federal Reserve Needs to Bury the Ghost of 1937."

"Most investors assume the prevailing lower-for-longer consensus is bullish for both equities and bonds," he added. However, Arone said his "view is that a tardy Fed has a good chance of proving bearish for bonds and, longer term, for equities as well."

The Fed's Open Market Committee gathers this week at a meeting that only a few months ago was expected to include the first rate increase in nine years. However, slower-than-expected economic growth has taken some of the urgency off the expected tightening.

Now, traders at the Chicago Mercantile Exchange aren't pricing in a hike until December. While Arone said he doesn't think the Fed should move now, he believes the risks of waiting too long outweigh those of tightening too soon.

"Risks in this environment are growing, not shrinking," he said. "The longer the Fed stays on this path, the more aggressively it may have to tighten and the crueler the asset price adjustment will be when it finally comes."

What's causing much of the consternation is fear that, like 1937, a desire to avoid bubbles and normalize rates will come too soon and plunge the economy back into a slump. The Fed took its short-term rates target down to zero amid the financial crisis and the Great Recession, and has been there since late 2008.

However, that recession officially ended in 2009, yet the central bank has not moved on policy. In addition to zero rates, it has boosted up its balance sheet to $4.5 trillion in a liquidity program whose effect has been to pump up the stock market by 220 percent.