How the Federal Reserve boxed itself in
By Barry Ritholtz,
Last week, the Federal Reserve announced it was lowering its forecast for the U.S. economy. The Fed now sees signs that economic growth is decelerating, job creation is soft and that deflation — not inflation — is the greater threat. In response, the Federal Open Market Committee took the unprecedented step of declaring they will leave interest rates at zero until mid-2013.
This policy announcement of “Two more years!” is a tacit admission that the U.S. Central Bank has painted itself into a corner.
How this unfolded is a sordid tale, with major ramifications for investors. I’ll share with you what I told clients this week: “This entire crisis traces itself back in large part to then FOMC chair Alan Greenspan not allowing markets and the economy to flush themselves clean after the dot-com collapse. It seems that nearly every Fed/government policy action has been a response to the problems that error led to.”
The Fed — unlike most other central banks — has a dual mandate: To maintain full employment and, at the same time, keep inflation at bay. History informs us that these two factors are often at odds: Growth usually begets price increases, and excessive price elevation retards growth. Hence, for the Fed to do its job well, it has a neat balancing trick to perform.
In the 1990s, the Fed drifted away from those mandates when Greenspan began focusing on markets, asset pricing and a nonsensical catch-all he called “investor confidence.” (Others may point you to earlier dates — you might check out Bill Fleckenstein’s book “Greenspan’s Bubbles.”)
With the bull market in full charge, Greenspan watched investor confidence more and more. This is a tough crowd to play poker with, and once traders deduced that Greenspan was concerned about their sentiment, his cause was lost. It became quite apparent that at the first sign of any market spasm, the Fed stood ready to flood the system with liquidity. In just four short years, markets saw massive Fed responses to the 1) Asian contagion (1997), 2) Russian bond defaults and 3) Long-Term Capital Management Collapse (1998), 4) Y2K bug (1999), 5) Dot-com implosion (2000) and 6) 9/11 (2001).
Thus was born the Greenspan put. Investors had determined that Greenspan would not allow stocks to drop appreciably. This led to appreciably more aggressive trading postures, increased usage of leverage and an overall embrace of risk.
There was no small irony in this. Greenspan — Mr. Free Markets himself — had somehow morphed into Mr. Centrally Planned Economy. This was not lost on the Wall Street community, whose bonuses depended on sniffing out the most lucrative opportunities. What was becoming the obvious answer to that question was wherever Fed liquidity was driving asset prices. For the late 1990s, the answer was upward.
Following the Y2K cash infusion on Oct. 22, 1999, the Nasdaq doubled from 2,500 to 5,100 in six months. The 78 percent collapse it suffered overstates what should have been a more typical 50 percent crash (say 2,500 down to 1,250) had the Fed intervention not occurred. (Savvy traders saw parallels to this in August 2010, when the Fed announced QE2.)
Then came the dot-com crash. Fed Funds rates were at 6 percent in early 2001 before the Fed began slashing them. They made eight rate moves between January and August 2001, cutting rates in half to 3 percent. Note this was before the Sept. 11, 2001 attacks. It looked to this observer that Greenspan was panicked by the market reaction to the terrorist attacks: He took rates all the way down to 1.25 percent. At the time, it was unprecedented to have rates below 2 percent for three years, and at 1 percent for a year.
This unprecedented Fed intervention unleashed a series of unfortunate events: Bond managers scrambled for yield, ultimately finding AAA-rated mortgage-backed junk products. The dollar plummeted 41 percent over the next 7 years. Anything priced in dollars — oil, gold, foodstuffs — skyrocketed, sending inflation screaming higher. Housing took off, loan standards collapsed, credit quality suffered.
Of course, there were other factors: Radical deregulation, globalization, labor restructuring, flat income, the rise of Asia and more. But it’s hard to imagine the rest of the 2000s as the debacle it became without this initial Fed overreaction.
Indeed, we can only imagine what the 1990s and early 2000s would have been like had the FOMC been more Volcker and less Greenspan. Former Fed chair Paul A. Volcker was a no-nonsense central banker who believed that the Fed’s job was to fight inflation. Whatever happened in the stock market was none of his concern. If you bought Russian bonds and they defaulted, you were supposed to lose your money. Bought into a bad hedge fund that blew up? You took the hit! The dot-com collapse should have led to a flushing out recession and market crash that took a few years to recover from. Not, as was the case, an attempt to offer a salve to leveraged traders who were caught leaning the wrong way when the tide went out.
What we got instead was the Greenspan Fed. The ills caused by cheap money and excess liquidity were apparently to be solved by even cheaper money and more liquidity.
Many of the subsequent problems of the U.S. economy derive from those decisions from a decade or more ago. They have been compounded by a variety of other bad calls; it’s not all the Fed’s fault. But much of what ails us traces back to the Greenspan Fed.
The easy money that corrupted Wall Street and shook the world economy was the prime spark to the wildfire. Had a more normalized Fed policy been in effect, much of what took place in the 2000s very well would have gone down quite differently. We most likely would have had a deeper, more painful recession in 2007-09, but we would be further along the path to recovery today.
Instead, we are like the late-night reveler who forestalls the hangover by having another drink. And another. And another, until we discover that we have become alcoholics.
For the long-term investor, this has created all manner of problems. Fixed-income yields remain thin; those seeking to live off of their assets find it increasingly challenging to do so. Stocks that yield dividends can help, but they come with additional risk and volatility. The average investor is not a momentum trader, but that momo crowd squeezes the most profit out of an easy Fed.
Which brings us back to this week’s FOMC announcement. We won’t see protestors in the street carrying signs reading “Two More Years!” but that is all it has left to give. The Fed cannot raise rates, lest it triggers another recession. And the Fed cannot keep rates here forever, lest it admits its own policy failures, debase the currency further and send oil over $100 and gold toward $2,500.
It is boxed in. And it has no one to blame but itself.