Is the Federal Reserve About to Burst Another Asset Bubble?

At its ongoing September 2009 meeting, the Fed is considering how and when to withdraw the myriad liquidity accommodations it has provided to stabilize the financial system. Conventional wisdom holds that the Fed should proceed very gradually, and only if the financial sector doesn't whimper, lest the fragile economic recovery be jeopardized. Great fear is expressed of precipitously taking away the punch bowl just as the party is getting going. Grave allusions to the Fed's stinginess in the 1930s are made with knowingly raised eyebrows. Official winks and nods signaling continued easy money are aimed at the center of the financial district.

But we seem to have a fresh set of asset bubbles. The stock market has had an extraordinary rebound. Oil prices have bounced back from their winter lows without much increase in underlying demand. Let's remember that in money matters, if it looks too good to be true, it probably isn't true. The current financial recovery hasn't been matched by a corresponding recovery in the real economy. There, sightings of green shoots are all that can be reported amidst growing unemployment. When asset prices rise without a lot of good reason, keep your hands on your wallet and your cash in safe places.

After the last ten years of Fed easy money instigated asset bubbles in tech stocks, real estate, mortgage credit, and petroleum, one can't avoid suspecting that today's bubbliness is the result of the Fed's liquidity accommodations. To make things worse, the big banks are smack in the middle of the current asset bubbles and would probably be hammered if things fell apart. The Fed is making noise about winding down its accommodations well before anything happens, probably in the hope that plenty of notice will give the big banks time to prepare for the end of the party. But will this work? There was plenty of notice of Bear Stearns' problems, yet a federal bailout was necessary to prevent panic when the Bear went down. There was even more notice of Lehman's problems, but who was prepared for its bankruptcy? AIG's problems should have been apparent to the credit default swap buying crowd, since those swaps were for mortgage-backed investments and AIG's principal counterparties were major financial institutions that were well-aware of the mortgage mess. Yet AIG got a whopper of a bailout because way too many big banks were way too exposed.

Giving notice won't do much to curb Wall Street's excesses. Why? Because Wall Street is the home of the short term. If there's a short term buck to be made today, then damn the torpedoes and full speed ahead. This quarter's earnings and this year's bonus depend on short term profits. The Fed's easy money policies have made short term trading and speculation highly profitable and profitability is a competitive issue. A firm's ability to hire and retain the best personnel depend on high profits and a booming stock price. Just about every major bank has serious Goldman envy, and they wouldn't be inclined to back away from a short term speculative trade if they thought they'd have to report lower profitability than GS. As long as the short term profit song is playing, everyone is going to keep doing the short term dance.

So when the Fed, sooner or later--well, probably later--begins to withdraw its accommodations, the current ongoing bubbles may well deflate, and the Street won't be prepared. Cries for federal intervention will recur. But what could the Fed do at that point? Its zero interest policy would have been a cause of the problem, not the solution.

Yet the Fed can't keep all this accommodation out there indefinitely. There is, ultimately, a risk of inflation. The Fed is at a fork in the road and may be damned whichever way it goes. Unless fiscal policy or something gets the real economy going, things could be ugly. Let's just hope that when this dervish stops whirling, we don't all collapse into a feverish coma.