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.

A Question for the Chairman: Is the Fed Doing Its Part to Reduce the Federal Deficit?

This week, Chairman Ben Bernanke of the Federal Reserve holds the first ever press conference by a Fed Chairman. The wisdom of opening himself up to volleys of dumb, loaded, and unfair questions isn't crystal clear. Since, however, he's voluntarily decided to position the seat of his pants in the middle of a firing range, here's a question that should be posed to him.

It's Econ 101 that the lower the price of something, the more of it people will consume. Isn't the Fed making it easy for the federal government to run massive deficits by keeping interest rates ultra low?

The stated purpose of low interest rates is to stimulate the economy. But they also stimulate government borrowing. Look at Japan. Its public debt is something like 200% of its GDP (America's is around 70%). But interest rates in Japan are so low that the government's annual bill for borrowing all this moola isn't terribly painful. Most Japanese government debt is held by Japanese citizens, who seem perfectly willing to refinance the government every time its debt falls due, asking for scarcely any interest income at all. From an economic standpoint, it makes sense for the Japanese government to keep borrowing. Since it can roll over maturing debt at will for ultra low rates, it never really needs to control its deficits and can keep borrowing more at minimal interest expense. The U.S. Treasury, too, can easily roll over its debt at historically low prices. So its need to reduce deficits isn't pressing.

The Fed's low interest rate policy is inflating commodities and equities, but its impact beyond that is unclear. Big banks aren't increasing the net amounts of their loan portfolios and small businesses still limp along with working capital from their owners' credit cards. Real estate remains moribund, with more of the same expected for the future. Raising interest rates will make financial markets speculators unhappy. But let's remember that central bank manipulation of asset prices doesn't produce lasting prosperity, but indeed the opposite (for further reading, see 2007-08 financial crisis).

For all the political hoopla over deficits, reality is that money talks and bullsh . . . uh, political dialogue walks. What's forced Greece, Ireland, Portugal and other Euro bloc nations to rein in their spending? Not frowning bureaucrats in Brussels, but rising interest rates demanded by their creditors. Chairman Bernanke recently scolded Congress and the administration for not doing enough to reduce the deficit. Well, remember, Mr. Chairman, money talks and bu . . . well, you know. If you want the government to reduce the deficit, make it pay for borrowing.

Will the Fed's Easy Money Slow the Economy--Again?

It is widely believed (albeit not at the Fed) that easy money policies by the central bank have contributed substantially to the asset bubbles and busts of the past decade. Tech stocks, real estate, consumer credit (remember the days when anyone with a pulse and a signature could get a loan?), and commodities (especially oil) all boomed and busted partly because of low interest rates fostered by the Fed. Each cycle enriched financial markets insiders, but weakened consumers and the broader economy. Nevertheless, the Fed is at it again with quantitative easing (i.e., buying Treasury securities in the open market) and history may be repeating itself.

Oil prices have risen above $90 a barrel, and predictions for $100 oil are becoming fashionable. Regular gas is more than $3.00 a gallon. Metals prices have been rising, and today's Wall Street Journal (P. C1) reports that holdings of metals have become concentrated, suggesting a flare-up of speculative buying. With the economy still struggling to climb out of the septic tank, the liquidity the Fed has been pouring into the financial system apparently isn't being used to build factories or develop software, or for badly needed repairs of bridges and highways. It evidently is going into short term financial market plays, the same kind of stuff that's bedeviled the economy for the past decade.

The Fed wants inflation to stimulate consumer spending. It may well get a dose of inflation this year, if oil and other commodities prices keep rising. But that isn't beneficial inflation. As gasoline, heating oil, diesel and aviation fuel go up, consumers spend more on energy and less on everything else. Oil producers get wealthier (perhaps increasing funding for Iran's nuclear weapons program), while American businesses struggle to keep sales up. Hiring may slow, retarding the recovery of employment levels. The economy could stumble. This is what happened in 2008 and it could easily happen again.

Just when everyone thought fiscal stimulus was dead, the Republicans ignored the mandate from voters in the recent mid-term elections and agreed to a tax deal with President Obama that increased the federal deficit. Okay, so the increase was necessary to give tax relief to the wealthiest Americans, who are major targets of campaign fundraisers now that the Supreme Court has ruled that political sugar daddyism is a Constitutional right. But it demonstrates that fiscal expansiveness lives. John Maynard Keynes' legacy may yet be vindicated by the GOP.

The Fed has powerful monetary tools. These tools, however, can have powerful unintended consequences. Need the Fed pile on with more easy money?

As a bank regulator, the Fed has appropriately been leaning on its regulatees to be more prudent. Perhaps, just perhaps, it ought to consider whether prudence might not be a weapon in its monetary arsenal as well.

The Federal Reserve's Discount Rate Hike: Are Market Forces Returning?

After the stock market closed today, the Federal Reserve announced that it was raising the discount rate by 0.25%, from 0.5% to 0.75%. This increase has little direct impact on the banking system, since banks rarely borrow from the Fed's discount window. But it may be a momentous signal. Since the fall of 2008, the Fed has been in total crisis management mode, with nary an accommodation that was too extreme to provide to the financial markets. It virtually gave away credit to banks and other financial institutions in an effort to prevent panic. And, last year, even while the stock market zoomed upwards some 60%, the Fed still aimed to serve and please the banking system with every imaginable amenity. As recently as last month, it still anticipated maintaining "exceptionally low levels of the fed funds rate for an extended period."

But today's announcement was made in between Open Market Committee meetings, when rate decisions are normally made. The most recent meeting was Jan. 26-27, 2010, and the next one is March 16, 2010. Rate changes in between meetings are unusual, and can be interpreted to mean that we aren't in a business as usual mode. Although a Fed governor was quoted by news services this evening as saying that the discount rate hike isn't meant to "signal any change in the outlook for monetary policy" and is just "further normalization of the Federal Reserve's lending facilities," the markets had the opposite take. The dollar jumped in afterhours trading, as did short term U.S. interest rates. Asian markets opened to the downside and overnight trading in U.S. stock index futures moved downward as well. The markets sense a shift in the wind.

The most likely reason for today's out of the ordinary rate hike was the Producer Price Index report this morning, which revealed that the PPI jumped 1.4% last month. On an annualized basis, that would be close to 17%. No one expects inflation this year to be anywhere near 17%, but any suggestion that inflation would be more than very low would put the Fed under pressure to raise rates. The Fed has pumped an extraordinary amount of liquidity into the financial system in the last year and a half, and, if inflation flares up, this heap of liquidity would be like dry tinder in a forest after a drought.

Stocks today ignored the PPI report, with the Dow Jones Industrial Average rising 83 points. That probably was because the Fed has seemed so nonchalant about inflation risk. But clearly something has happened in the minds of the Fed governors, something that was quite opaque until today's discount rate hike after the market closed. It may well be the higher risk of inflation that today's PPI report revealed. It might also involve China. The Chinese central bank has been raising the interest rate it pays on bank reserves, a measure designed to reduce liquidity in the banking system and cooling off the bubbly real estate and credit markets, and rising inflation, in China. Because China continues to informally link the yuan to the dollar, excessive liquidity pumped out by the Fed could spill over into China and counteract what the Chinese central bank wants to accomplish. America needs Chinese as a source of credit for its massive federal deficits, and the Fed probably wants to stay on good terms with its Chinese counterparts.

The Consumer Price Index for January 2010 will be announced tomorrow (Friday, Feb. 19, 2010) morning, before the stock market opens. You can bet that traders will be much more focused than yesterday on the announcement. And there are probably good odds that the CPI will be uglier than people anticipated yesterday. The high PPI was driven by an unusually large jump in gasoline prices (5.1%) and an 0.4% increase in food prices. Gasoline and food would have significant impact on the CPI. Light truck prices as included in the PPI rose 1.9%, and would also impact the CPI, as light trucks continue to be half or more of the automotive market.

If the CPI number is bad, you can expect short term interest rates to edge higher. Although a sizeable increase isn't likely until the Fed allows the fed funds rate to rise, the markets can no longer assume the cheapest of all imaginable government-subsidized credit. As interest rates rise, the costs of speculation rise, since interest charges and repayment obligations are a certainty. But profits aren't. It begins to make less sense to dive into high risk derivatives and commodities bets, even if they offer potentially high returns. Market forces forced into the wood work by the Fed's zero percent interest rate policies may now emerge. Money managers and speculators might have to re-evaluate and perhaps retrench. Stock prices could go wobbly.

But the potentially good news is that money no longer deployed in financial speculation could wend its way into the real economy. Businesses starting to see upturns in order flow may find banks a little more willing to lend to them. Most small businesses can't compete for credit with Wall Street speculators betting on asset prices bubbling up in a zero percent interest rate environment. But add an element of risk to speculation, and lenders may begin to see the attraction of lending to businesses with orders in hand.

You Were Worried Obama Would Redistribute Income? Life is Just an Asset Bubble.

The moneyed classes need not have worried. During Barack Obama's Presidency, their wealth, if anything, has grown. The stock market is up from the end of the Bush, Part Deux years. This favors the well-to-do, who own most of the stock. Oil prices have risen sharply; OPEC and other oil producers worldwide are celebrating. The Federal Reserve's interventions have financed, not new loans, but stability for banks, big bonuses for bankers and nice gains for bank shareholders. Ordinary folks have benefited from the federal stimulus package. But the well-to-do have benefited more, since they had more to lose and their larger holdings of assets have enjoyed greater gains. Yes, the high end of the real estate market is slow. But most wealthy people--i.e., those with net worths over $5 million--have well under half their net worth invested in their homes. These are today's equivalent of coupon clippers and their wealth is mostly invested in financial assets.

The last point is important. It's not that the President is trying to make the wealthy wealthier while leaving the poor behind. He isn't. It's just that when the Federal Reserve and federal fiscal policy do things to help fix the economy, those things tend to favor the already prosperous. In recent years, Federal Reserve monetary policies have involved dumping large quantities of cheap credit and printed money into the economy. When the government prints money, as it is doing now, that money is like a flood. It has to go somewhere. Inflation hasn't been a problem. With rising unemployment, falling real estate values and thoroughly cowed consumers, retailers can't raise prices. They'd only scare off more customers. Instead, the money's been going into asset markets. Wealthy people own most of the assets, so when assets bubble up, wealthy people pocket most of the gains. This is an important reason why some investment banks are suddenly doing very well and paying large bonuses. They are dealers in asset markets--and participate in the gains from the asset bubbles.

An irony of all this is that the Fed was created to smooth out the economy's ups and downs. It was supposed to be a lender of last resort to banks in bad times, and a prudent regulator that would restrain banks' reckless tendencies in good times. Now, the Fed has become pro-cyclical as a regulator--seeing, hearing and speaking no evil while much evil was done in boom times, but cracking down when the economy slumped--and a printer of money too much of the time. The result has been an exacerbation of economic cycles. Realistically speaking, there's no going back on the idea of central banking. But the question arises whether the Fed is abusing its privilege to issue fiat money and should be subject to statutory constraints. It's no longer enough to require the Fed to control consumer price inflation. It also has to control the impact of government handouts of liquidity on asset markets.

Asset bubbles feel good at first. Owners of assets receive speculative profits, and spend the stuff like found money. Remember the way so many people burned up their home equity on good times? But the good times have passed while the debts remain. The bubbles created transitory prosperity, and lasting economic damage.

The Fed has announced that it will begin to withdraw the myriad accommodations it's provided to the financial system, although it has barely managed to inch forward thus far. What could easily happen when it really begins to retrieve some of the trillions of dollars of handouts would be increased mortgage rates, which would heighten the distress in the real estate markets, a falling stock market (and political repercussions from the concomitant drops in 401(k) accounts), and a further tightening of bank credit. Maybe credit cards would altogether disappear except for the wealthy, while home equity loans would be mentioned in the same breath as Triceratops. There would be political howling of the first and to the nth degrees. The Fed would probably back down and take the easy way out, printing money three shifts a day to shoot up the liquidity junkies again. Only once in its history has the Fed chosen integrity over expediency, when Chairman Volcker raised interest rates and held them up in order to quell the inflationary surge of the 1970s. To this day, he remains marginalized by Wall Street and official Washington for his uprightness.

So life has become a series of asset bubbles. If you're feeling blue because of portfolio losses, don't lose heart. The Fed will pump up asset values again sooner rather than later.

And if you're not a member of the moneyed classes and need a paycheck to put food on the table, you might see some wealth redistribution come your way when health insurance reform is enacted--whenever that is.

How the Current Stock Market Crisis Grew in the Tulip Garden

Another day, another 207 point drop in the Dow. When you're feeling pain, it's hard to think about anything else. But it might help to step back and think about why we have this pain.

The current market turmoil is a consequence of the loose credit policies of the Greenspan era at the Federal Reserve. We've discussed how repeated loosening of credit in response to market instability created expectations that the Fed would always step in to protect asset values. See http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html. Low interest rates facilitated the dot.com boom in the stock markets. A years-long policy of very low interest rates after the terrorist attacks of 9/11/01, supposedly intended to prevent price deflation, triggered a massive inflation of real estate values. Apparently the Fed, and in particular Chairman Greenspan, thought that a vibrant real estate sector would stimulate the economy and keep things humming. A busy real estate market would employ a lot of people: construction workers, real estate agents, mortgage brokers, title company personnel, bank loan staff, investment bankers packaging CDOs, hedge fund managers, and even an occasional home inspector (although not at the height of the lunacy).

Even more importantly, home values rose. That gave homeowners greater equity, even if they had done nothing to earn it. Simply holding title to real estate meant greater wealth. And you know what they say about easy money: easy come, easy go. The banks made it even easier, offering home equity loans and lines of credit to anyone with a home and a pulse. People eagerly converted their no-sweat equity into cars, big-screen TVs, overseas vacations, backyard grills large enough to roast an ox, bathrooms that cost more than a year at a private college, kitchens that cost more than a full-size luxury sedan, and diverse and sundry other indicia of prosperity.

Given that you could buy a home with no money down and no proof of your income, and then get access to rising home equity that would finance a lifestyle that your earnings, if any, couldn't begin to cover, who wouldn't buy a house? Come up enough eye-hand coordination to sign some paperwork, and you'd be driving the car of your dreams to the home of your dreams for the backyard barbecue of your dreams. And your guests would be too busy sticking their faces in two-inch thick steaks to notice that you hadn't gotten any smarter, worked any harder, earned any more, or saved a penny.

The asset boom had a wonderful quality of rotating from a faltering market to a fresh market ripe for exuberance. When the real estate market peaked in 2006, the stock market took off. Much of its rise was fueled by speculation in the stocks of companies thought to be good candidates for going private transactions. Hedge funds, as well as individual investors, used leverage to buy stocks of companies they hoped the private equity firms would use leverage to acquire.

The loose credit policies of the Greenspan era rewarded asset speculation. Further, as asset prices rose, speculation on a leveraged basis was rewarded even more highly. The financial services industry, ever eager to pounce on a profitable trend, developed ways for every Tom, Dick and Harry, however indigent, to engage in leveraged speculation.

On the other hand, those dull, boring and unimaginative people who worked hard, lived within their means, paid their debts, and saved were duly punished. The ultralow interest rates of 2001 to 2005 drove interest rates paid on bank deposits and money market funds below 1%, not enough to begin to offset inflation. Why save a downpayment when: (a) you would lose value from inflation on your short term investments, and (b) you could buy a house without a downpayment--or any other verifiable financial resources? Old-fashioned virtues such as moderation, thrift and long term planning had sand kicked in their faces by the luxury car leasing, credit card wielding, minimum monthly payment making swells of the leverage loving classes.

Now, however, the chickens have come home to roost; and the home is in foreclosure with hardly a hot dog to throw on the grill. Here's the problem: you can't build true economic wealth by speculating in asset values. No asset will increase in value indefinitely. The Dutch learned that lesson from their little spending spree on tulip bulbs. While the commodities markets provide valuable grease to keep the wheels of the economy turning, you can't have an entire society trying to get rich from speculative investing. That would lead to a cycle of asset sales at ever escalating prices, where recklessness and, ultimately, stupidity are the only things keeping the lemmings going. However, since no asset can rise in value indefinitely, when the lemmings reach a cliff, Newton's law of gravitation becomes operative.

True economic wealth comes from productive activity (meaning work). Okay, work stinks, but it's better than losing your house to foreclosure. True personal wealth means having a positive net worth, not a lot of debts. True national wealth comes from production of goods and services, not asset speculation, and requires having a positive savings rate that provides capital to finance investment.

The loose credit policies of the Greenspan Fed penalized work and saving, which would generate income taxable at ordinary income rates. The same policies rewarded speculation in assets, which would generate capital gains taxable at lower rates, or real estate gains that wouldn't be taxed at all. Interest paid on mortgage debt would be deductible, while interest received for savings would be taxed as ordinary income. Granted, the Fed didn't create the tax code. But it knows how the tax code works and doesn't have to misallocate resources worse than the tax code already misallocates them. A rational, thrifty and hardworking person would think the entire world had fallen down a rabbit hole.

The Greenspan Fed's loose credit policies were a form of pump priming, deficit spending that is leaving a lot of people with individual real estate or stock holding deficits. While these policies temporarily provided some stimulus, the piper meticulously kept a ledger and now has come around to be paid.

Norman Rockwell wouldn't recognize today's America. McMansions consume the entire lot, even the edge where the white picket fence once stood, and soda fountains now charge $5 for a cup of coffee. The current Fed's kabuki dance to maintain confidence by infusing liquidity, while keeping interest rates stable in order to discourage the speculative use of credit, may be the right medicine. The Fed seems intent on not administering narcotics this time, so we will probably continue to feel some pain. Addictions are hard to break, but being sober and healthy would be worth the pain.

Legal News: no CSI for jurors. http://www.wtop.com/?nid=456&sid=1218187. Is it any wonder people don't like jury duty?