As I listened to Fed Chairman Ben Bernanke testify to Congress on TV yesterday, I couldn’t help but draw parallels to the early part of the new millennium. Alan Greenspan was the Fed Chairman during this period of great turmoil in our country. At the time, nobody could have asked for a steadier hand to guide us through some pretty severe storms. In response to the bursting of the tech bubble and the 9/11 terrorist attacks, Greenspan lowered the Fed Funds rate from 6.5% at the beginning of 2001 to less than 2% by the end of 2001. The rate stayed below 2% for the next 3 years. This “loose money” policy undoubtedly cushioned the blow of some pretty serious shocks to our economic system. But as we all know, low interest rates also unleashed a wave of speculation in residential real estate, the likes of which we had never before seen. Several years of rampant speculation culminated in the bursting of the real estate bubble in 2006-2007. We have been recovering ever since.
As housing prices soared to ridiculous heights in the first decade of the new millennium, I can recall wondering why housing prices were not included in official measures of inflation. After all, housing is likely to be a family’s largest expense. Instead, the most common gauge of inflation, the CPI, uses “Owner’s Equivalent Rent”, which is the amount of rent one must pay to live in a comparable house. The OER was not rising nearly as fast as housing prices because investors were making highly speculative bets on homes in the hopes of flipping them for a quick profit. Had housing prices been incorporated in the official measures of inflation, Greenspan surely would have thought twice about maintaining low interest rates for so long. And had Greenspan hiked rates earlier, we may have been spared much of the speculation that inflated the housing bubble to ridiculous proportions.
Is Bernanke doing the same thing right now? In contrast to Greenspan, Bernanke is not coy about his targeting of asset prices as a way to cure us of our economic woes. On November 4, 2010, Chairman Bernanke published an op ed in the Washington Post designed to drum up support for a second round of asset purchases by the Fed (”QE2″). In this article, Bernanke said the following:
“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
The targeting of stock prices struck me then, as it does now, as a dangerous precedent. My fears were amplified yesterday as I listened to Philadelphia Fed President Charles Plosser. Plosser, who has been among the most hawkish of the Fed governors, ratcheted-up his rhetoric in a recent interview with CNBC’s Maria Bartiromo. According to an article on CNBC.com, Plosser said “he doesn’t want the U.S. central bank to get into a situation where the public expects it to buy bonds to manipulate securities prices, a possible “dangerous” situation for which the Fed doesn’t yet have a model to turn to for guidance.” Um, aren’t we already in that situation? And let’s not just consider stock prices. What about bond prices? Given that intermediate-term Treasuries now carry negative real interest rates (adjusted for inflation), wouldn’t bonds be considered in bubble territory?
Aside from securities prices, inflation seems unlikely to be a major problem in the very near term. Capacity utilization remains too low, and unemployment remains too high. However, Plosser and others are increasingly worried that the longer we wait, the more difficult the inevitable problem will be to contain. We have long felt that the Fed has been targeting housing prices, as well as stocks, as a way to lift the economy. And if this is indeed the case, shouldn’t the Fed be considering asset price inflation in formulating its monetary policy? Stock prices have risen over 100% since their March 2009 lows. And while housing prices are still in the doldrums, it’s hard to argue that they wouldn’t be much lower without the government and Fed support.
For my part, I continue to believe that a long, slow process of consumer and government deleveraging must take place before the economy can return to a period of sustained strength. However, this process cannot be expedited by loose monetary policy. If anything, the problem is exacerbated by low interest rates as this encourages more borrowing. In other words, it doesn’t make sense to solve a problem of too much debt by encouraging the assumption of more debt. Moreover, the Fed’s aggressive monetary policy is risky because it can cause new asset bubbles (as well as more widespread inflationary problems). With the housing bubble so fresh in everyone’s minds, the Fed’s actions are very surprising. And finally, we believe that investors have become addicted to Fed (and foreign central bank) intervention in the economy. Stocks and bonds seem to only move higher with the announcement or promise of new central bank action. This cannot be healthy.
It would be nice if the Fed could simply use monetary policy to return us to full employment and economic health. But these actions do not come without significant risk. This is dangerous, and the Fed should look to extricate itself as quickly as possible. The Fed helped to save us from crisis but cannot and should not be attempting to rescue us from all consequences.