Recently the debate has heated up regarding the Fed’s role in not only bubble bursting, but also bubble creation. Alan Greenspan has even publicly chided those critics who have voiced their objections to monetary policy carried out during his reign as Fed Chairman. Eight years ago such criticism was not only uncommon, but would have been considered heresy. Mr. Bernanke’s skeptics have been somewhat less vocal, but some are active as well. Let’s recall some of the history to see why.

As we approached Y2K, financial institutions, corporations and the Fed all became nervous that many automated systems would simply become non-functional. As a result the Fed injected liquidity into the financial system in the late 1990s to offset any slowing economic effects that such potential dysfunctions would create. This helped fuel the tech bubble, and by late 1999 the Fed started increasing the funds rate to cool an overheating economy. The tightening worked, but soon the Fed reversed course again dropping the funds rate from 6.5% in May 2000 to 1% by June 2003 to stimulate an economy devastated by recession and the busting of the tech bubble.

This dramatic drop in rates revived the economy, but also helped to create an unprecedented bubble in housing (and possibly Treasury bonds) which in turn led to unprecedented levels of leverage by the financial community. Hedge funds and investment banks devised strategies that relied more on the use of leverage to produce returns than on underlying opportunities.

By early 2006, the Fed again started raising rates to 5.25% in response to the speculative bubble in housing. As we all know, the bubble burst, and our current 2% fed funds rate is the result of yet another reversal of interest rate policy.

How can anyone believe this roller coaster volatility in liquidity helps anything? Is the Fed’s attempt to micro-manage creating more harm than good? Do things really change so much from month to month in the economy to justify such short term Fed moves, or are those moves creating volatility in financial conditions? How can we expect good long term decisions to be made by corporations and market participants with such volatile policy moves from our central bank?

Maybe the Fed is just as guilty as the investment banks’ quant models for the subprime mess; relying too much on their own theoretical beliefs and models. Pre-emptive actions in carrying out monetary policy are certainly necessary, but maybe a longer term time frame should be utilized. The ECB over the same time frame as outlined above has raised and lowered rates, just as the Fed, but in approximatley a 2.5% range, compared to the Fed’s 5% to 6%. The Euro has set records against our dollar, while their markets have outperformed ours and have attracted a large worldwide capital flows.

What should we learn from this? Certainly, the Fed is not totally responsible for the subprime debacle and its current stringent credit environ, but an argument can be made that it was an unknowing participant in creating unprecedented ability to leverage. Hopefully, next time the Fed will look inward and not just outward when designing monetary polic and the hedge fund community will retain its new-found knowledge that leverage is often more a function of risk than return.

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The views expressed in this column do not necessarily reflect the views of Channel Capital Group. Inc.