Oops, Has the Fed Done It Again?
11/09/2010 10:00 am EST
The Fed contributed mightily to two financial bubbles over the past decade. Now, it seems bent on a course that will create another in the world's emerging economies.
2000. 2007. 2011.
Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?
Asset prices in the world's emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world's emerging economies have started to worry about what will happen if all the hot money flowing into their economies and markets suddenly starts flowing out.
"As long as the world exercises no restraint in issuing global currencies such as the dollar," Xia Bin, an adviser to the People's Bank of China, said, "then the occurrence of another crisis is inevitable."
(For more about reaction to the Fed's latest decision to push money into the economy, see my blog post "Everybody loves Ben's $600 billion—at least in the short term.")
I think some degree of worry—less than full panic but more than polite concern—is appropriate at this stage. And that worry should play a role in shaping your investment strategy as the decade advances. In today's column, I'm going to lay out the "Oops, the Fed's done it again" scenario. Later this week, I'll tell you what I think you can do about that danger.
Just Talking About Exuberance
In 2000, I'd say the sin was one of omission. The Fed sat on the sidelines, aware that a stock market bubble was building but doing nothing to head it off.
Remember how then-Fed Chairman Alan Greenspan talked about "irrational exuberance"? Well, it was all just talk. The Fed, which had the power to try to moderate the bubble by tightening credit on Wall Street, believed that trying to manage bubbles was futile. All a central bank could do was watch from the sidelines and then help clean up the wreckage.
And quite a bit of wreckage there was and still is. The Nasdaq Composite Index peaked at 5,048.62 on March 10, 2000, and bottomed at 1,114.11 on October 9, 2002. That was a loss, top to bottom, of 77%.
Eight years after the October 2002 bottom, the Nasdaq composite is up handsomely—131% as of November 5.
But ten years after the bear market began in March 2000, the Nasdaq has barely recovered half its losses. From a high of 5,048.62, the market had clawed back to 2,578.98 at the close November 5. That means the Nasdaq Composite Index is still down 49%.
Making a Mess
I'd put the Federal Reserve's role in the financial and economic crises set off by the US mortgage mess in a different class. The sin here was one of commission. The Fed played an active role in creating this global meltdown and in making it as bad as it was. (Or should that be "is"?)
To clean up the wreckage from 2000, the Federal Reserve lowered short-term interest rates. At the Nasdaq Composite's height in March 2000, the Fed's benchmark rate was 5.73%. The central bank kept rates above 5% for an additional year—the benchmark rate was at 5.47% on March 7, 2001—but then it began to cut, and fast. By March 6, 2002, short-term rates were at 1.74%, and by the end of 2002, they were just 1.23%. By July 2003, the Federal Reserve had cut them to 0.96%.
And there they stayed. For too long, the Fed now concedes. A year later, through most of June, short-term interest rates were just 1.11%. That marked the turn in the cycle. Finally, on June 30, the Federal Reserve began to raise interest rates, though very slowly.
By the end of the year they were at 2.27%. By November 2005, they had finally reached 4% again. And by June 2006, short-term rates crossed the 5% barrier.
But by that time, the low interest rates that had been intended to help clean up the wreckage of the bear market of 2000-2002 had set off their own bubble, in real estate and lending.
NEXT: The Housing and Mortgage Bubbles Burst|pagebreak|
In the fourth quarter of 2002, when short-term interest rates were 1.23%, the real median price of a US house was $197,219. (All these prices are corrected for inflation.) By the fourth quarter of 2005, the real median price was up to $262,634. That's a 33% increase in the median price of a house in just three years—without inflation. That's extraordinary appreciation for an asset like a family home in the United States.
And cheap money made it possible. It was possible to buy and flip for a quick profit. Possible to refinance and take money out to buy more stuff. Possible to buy more house than you could afford. Possible to find a lender who would lend you more than the house was worth. Possible to find a lender who wouldn't ask questions about your income or credit record.
By 2006, this price appreciation had peaked. The median real price of a house that year ranged from $250,000 to $263,000. But by the second quarter of 2007, it had dropped below $250,000. And it kept on dropping. By the bottom, which nationally may have been the first quarter of 2010, the real median price of a house was down to $169,158.
That's a drop of 36% from the 2005 quarterly peak to what may be the bottom in 2010. (And because the house they live in is by far the most valuable asset most families own, and because homeownership rates in the United States are much higher than stock ownership rates, that 36% drop in housing prices was more devastating for most families than a 77% drop in stock prices.)
Trust the Fed Again?
That track record suggests that "What, me worry?" isn't a reasonable response to the Federal Reserve's two rounds of quantitative easing, a strategy that pumps money into the economy to try to get it moving more quickly. The first round, which ended only this spring, saw the Fed buy $1.7 trillion in Treasurys and mortgage-backed securities. The new round announced last week would add $600 billion in Treasury buying to the total.
The dangers of these two programs to the US economy are scary enough. The Federal Reserve is buying all these debt instruments on the cuff. The Fed doesn't actually have the money to pay for these purchases. Instead, it is creating dollars out of thin air—printing them, figuratively at least—and at the same time creating a huge liability on the Fed's own balance sheet. Of course, the Fed may be able to pay off that liability by selling the bonds back to the market someday, but you're entitled to wonder where the buyers for $2.3 trillion in US debt and mortgage-backed debt are going to come from.
If you're the kind of person who worries when you see a big debt and no obvious way to pay it off, then the Federal Reserve's current balance sheet undoubtedly worries you.
But even if you shrug off the Fed's balance sheet, the Fed's current course presents—what shall we call them—challenges for the US economy. That $2.3 trillion in quantitative easing is potentially inflationary: Pumping that much money into the US economy will, eventually, push up the prices of all sorts of things. (Which in the short run is what the Fed wants, as long as the gain in prices is no more than 2% annually. Good luck fine-tuning that one.)
Putting 2.3 trillion new dollars into the world weakens the US dollar, making imports more expensive and driving down the US standard of living. At some point, that $2.3 trillion also drives up US interest rates, because you're got to pay people (mostly overseas people who are already holding a lot of US dollars) more to take all those dollars, and those higher interest rates will reduce the growth rate of the US economy.
MORE: Where the Next Big Bubbles May Form|pagebreak|
Go Overseas, Young Dollars
But those aren't the possibilities that worry me most or that have overseas central bankers screaming in protest. The big problem is what will happen to that $2.3 trillion created by the Fed. The dollars certainly don't all stay in the United States.
Would you, if you were a self-respecting dollar, stay here earning 0.13% (the yield on the three-month Treasury bill) or even 2.58% (the yield on a ten-year Treasury bond) when you could go overseas and earn 10.75% on Brazilian debt, 6.5% in Turkey, or 4.75% in Australia? Would you stay home buying real estate in a market that's barely begun to show a quiver of life, or instead plunk yourself down in Hong Kong or Mumbai or Rio? Would you stay loyal to US stocks, knowing that the US economy is growing at 2% a year, or go cavorting off to join the fast company in China or India or Brazil?
Yes, indeedy, the really big asset bubbles that the US Federal Reserve may be creating now aren't at home, but overseas—in the stock markets of Indonesia, in the real estate markets of India, in commodity prices in Australia. Everywhere the flood of dollars created by the Fed might wash up.
And because many of these asset markets aren't anywhere near as liquid as those in developed economies, $2.3 trillion can create a huge problem. India is thinking of slapping on currency controls, because so far in 2010, the country has seen a record inflow of $25 billion in overseas cash as stock funds buy Indian equities.
Twenty-five billion dollars is a problem? When the Fed is talking about $2.3 trillion?
Part of the reason that overseas central banks are squawking is that it's unclear what they can do about the problem. The flood of dollars is creating dangerous inflation— India's annual rate was reported at 8.5% in September—so the Reserve Bank of India raises interest rates to slow the Indian economy? Besides the hardship that visits on the poor of India who need the jobs that faster economic growth provides, raising interest rates just makes that country a more attractive destination for all those dollars looking for a home.
The nightmare, of course, is that those dollars flow out as quickly as they flowed in. That's exactly what happened in the Asian currency crisis of 1997. Most of the world's developing economies are in better shape and less dependent on external cash flows than in 1997, but these economies certainly aren't immune to disruption.
And even if they don't go the way of Thailand in the 1997 crisis, a huge outflow of hot dollars would send asset prices plunging, with who knows what effects on national financial systems and capital markets. Look what the mortgage crisis did to Lehman Brothers. (Remember it?) The mortgage crisis caused what were comparatively liquid and large markets to freeze tight. Financial and non-financial companies couldn't raise even overnight operating capital.
No wonder Brazil's finance minister, Guido Mantega, said with resigned anger: "Everybody wants the US economy to recover, but it does no good at all to just throw dollars from a helicopter. You have to combine that with fiscal policy. You have to stimulate consumption."
Fiscal policy? From a US Congress? I wouldn't hold my breath. Congress punted on fiscal policy decades ago. Even the Clinton administration's vaunted (and real) budget surplus was achieved by a deal between the secretary of the Treasury and the chairman of the Federal Reserve. If the politicians in Washington were capable of conducting fiscal policy, the Federal Reserve wouldn't be implementing policies like quantitative easing. Ben Bernanke and company know exactly how dangerous this course is. But what's the choice?
Later this week, I'll take a whack at figuring out what you and I, mere investors, can do to protect ourselves if the Fed is indeed doin' it again.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.