Mutual Fund Mania: Danger Signal For The Fed?

Fed watchers are convinced the Federal Reserve stands ready to tighten if economic growth remains strong and inflation shows signs of picking up. But economist David Hale of Kemper Financial Cos. thinks another factor could also prompt the Fed to act: the huge outflow of consumer savings from banks and money-market funds into equity and bond mutual funds.

So far, the mutual-fund boom has benefited the economy by allowing households to diversify their financial assets while encouraging buoyant underwriting activity in the bond and equity markets. But Fed officials are concerned, says Hale, because the mutual-fund industry is gathering assets so fast that it could overtake banking by next year.

Such a shift could have unexpected effects on the stability of financial markets, consumer wealth, and credit flows. Many consumers don't understand the risks that interest-rate hikes pose for equity and bond funds, and many believe that their investments are somehow protected by government guarantees.

All of this spells extra caution. If the economy grows at around a 3% clip in the months ahead and the flow into mutual funds continues unabated, "the Fed will feel justified in nudging short-term rates modestly higher," predicts Hale.