Is the Fed Banking on a Crisis?

Scary things can happen when a central bank prepares for a crisis and it doesn't occur. In the late 1990s, there was a great deal of handwringing over the so-called Y2K problem. Numerous computer programs written in the 1960s and 1970s didn't originally accommodate dates in the twenty-first century, evidently because no one thought they would be in use for that long. But they were, and vast armies of computer programmers were deployed to modify programs written in ancient, almost forgotten computer tongues like Fortran and Cobol.

The Fed, alarmed at the possibility that bank and other computer systems might abruptly fail at 12:00 am, January 1, 2000, flooded the financial system with liquidity during 1999, to combat the risk of a credit crunch at the outset of the new century. This liquidity had to go somewhere, and a lot went into stocks. In the last quarter of 1999 and the first quarter of 2000, the S&P 500 rose about 12-13% (or 24-26% on an annualized basis), and the Nasdaq rose by two-thirds (or about 135% on an annualized basis). We know what happened next--the tech bubble burst and stocks have never, on an inflation adjusted basis, returned to their March and April 2000 heights.

There was no Y2K crisis, as it turned out. The armies of programmers carried the day, and the world rolled right into the twenty-first century as if there had been nothing to worry about.

But the Fed's flood of liquidity set the stage for the crisis that actually occurred: the collapse of the tech stock bubble. Although tech stocks were bubbling anyway, the Fed made things worse by lowering the price of cash, thereby effectively escalating the price of stocks. The Fed's bargain basement sale on liquidity in 1999 was to the stock market bubble like gasoline poured on a prairie fire.

Since last fall, the Fed has been sending double and even triple trailer trucks filled with liquidity from its loading dock 24/7. It's ruthlessly stamped out any positive interest rates on the short end of the yield curve, and thoroughly cowed the long end. Its apparent rationales for such actions include preparation for crises such as the sovereign debt mess across the pond, Iran's nuclear ambitions, and so on. Not surprisingly, stocks have risen over the past six months. Liquidity has to go somewhere. In late 1999 and early 2000, it went into stocks. During the past six months, we seem to see something similar.

If there really is a crisis today--like a credit crunch in Europe from Greece's default (the Greek default has effectively occurred; all that's happening now is the negotiation of the exact amounts of the losses to be borne by taxpayers, bondholders, etc.), a war between Israel, Iran and who knows who else, or the real estate bubble in China pops--the Fed will probably look wise and prudent for having engineered the biggest liquidity dump in central banking history.

But if the Europeans somehow muddle through (the stock market's current assumption), Iranian nuclear ambitions are somehow constrained without use of force (the stock market's current assumption) and the Chinese government manages a soft landing (the stock market's current assumption), then what will happen with stocks? Since late last summer, the DJIA has risen about 18% (or 36% on an annualized basis). The economy has been improving, but hardly enough to account for this kind of upswing.

Price inflation has been comparatively low (although more of a problem for those with modest incomes than the top 20%). But asset inflation is alive, well and snarling. If we avoid a major crisis this year, stocks may well soar. And perhaps soar some more. But then what? We have an all too recent and vivid history of government engineered asset bubbles ending badly. Whether you think history repeats itself or only rhymes, things are starting to look disturbingly familiar.