The Fed's airheaded bubble orthodoxy

GOLD: $1,106.60 With interest rates so low, commodity prices are soaring -- and gold is leading the charge. An ounce of the precious metal now sells for more than $1,100.
GOLD: $1,106.60 With interest rates so low, commodity prices are soaring -- and gold is leading the charge. An ounce of the precious metal now sells for more than $1,100. (Karl Mathis/associated Press)
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By Steven Pearlstein
Friday, November 13, 2009

The Federal Reserve is still going through its "lessons-learned" exercise from the recent financial crisis, but there's one lesson it clearly has not yet absorbed -- the one about ignoring and enabling credit bubbles.

That's the only conclusion that can be drawn from the Fed's decision last week to not only keep its benchmark interest rates at zero but also let everyone know that it intends to leave them there for a good long time. In case anyone missed the message, Fed officials and other central bankers and finance ministers repeated their promise several days later at a meeting in St. Andrews, Scotland, where they vowed to not let up the gas pedals of fiscal and monetary stimulus. And on Tuesday, the point was driven home again by members of the Fed's policy panel in three separate speeches.

Not surprisingly, all of this sparked a week-long party in financial markets that had already experienced powerful rallies over the past six months. Even with Thursday's modest pullback on Wall Street, U.S. stocks are up 60 percent since March, and share prices in emerging markets have nearly doubled. Commodity prices are soaring once again, led by gold, which is now selling for more than $1,100 an ounce, and crude oil, which is up a whopping 126 percent since February. A rally in the junk-bond and third-world debt markets has driven interest rates back to where they were before the crisis. In urban China, India and Brazil, property prices have doubled in the past year.

"The markets are on a sugar high," Mohamed El-Erian, chief executive of Pimco, the giant money manager, told Newsweek's Rana Foroohar last week.

Judging from how sharply and quickly these prices have risen, it's a pretty good guess that most of the buying has not been done by long-term investors who are suddenly upbeat about the prospects of global economic growth. The better bet is all this is the handiwork of short-term speculation by banks, hedge funds, private-equity funds and other financial center wise-guys moving as a herd, financing their purchases directly or indirectly with some of that yummy zero-percent money provided courtesy of the Fed.

For many investors, in fact, the cost of money is effectively less than zero, as economist Nouriel Roubini likes to point out. If you borrow dollars at near zero percent interest in the United States, exchange the dollars for Thai bhat, and invest the bhat in government bonds paying 4 or 5 percent, you not only get the benefit of the interest rate arbitrage but you also gain when you sell the bond and exchange the bhat back into dollars that have since depreciated. Roubini calls it "the mother of all carry trades," and in recent months he calculates that it has been generating annualized returns for investors of 50 to 70 percent.

This carry trade is now so widespread that it has become a major factor driving down the value of the dollar against many other currencies and driving up the flow of hot money into a number of developing countries. Not only has it spawned stock, bond, or real estate bubbles in those countries, but it's also driven up the value of their currencies to the point that their exports are less competitive relative to countries, including China, that peg their currencies to the U.S. dollar. To counteract these trends, central banks in Thailand, South Korea, Russia and the Philippines have intervened in currency markets, buying up dollars and selling their own currencies. Hong Kong has tightened up on lending rules, while Brazil has put a 2 percent tax on capital inflows. Taiwan has banned foreigners from making certain types of bank deposits.

There's no way to know how long all this can continue before one of these bubbles finally bursts, the dollar spikes upward and investors all rush to unwind their trades at the same time. But it is a good guess that it will last as long as the Fed and other central banks indicate there is no end in sight for the current cheap-money regime. The longer they wait, the bigger the bubbles, and the bigger the mess to clean up.

All of which is why the recent statements by policymakers were so disappointing -- and so dangerous.

Despite the junk-bond and real estate bubbles of the late 1980s, the tech bubble and Asian financial crises of the 1990s and the credit bubble of recent years, the Fed stubbornly clings to an outmoded way of thinking and talking about the economy and monetary policy. Fed officials tend to give little weight to such "extraneous" factors such as asset prices, currency movements and capital flow, at least in public, and fear that focusing on them will cause them to lose sight of their core inflation-fighting mission. Moreover, like his predecessor, Fed Chairman Ben Bernanke still believes central bankers aren't smart enough to tell when a bubble has developed -- and even if they could, it would probably cause more harm than good to try to do something about it.

Janet Yellen, the president of the San Francisco Fed, is one of a small number of Fed policymakers who have begun to question the Fed's bubble orthodoxy, but even she declined to stray this week from the official line that the economy and the banks remain so weak that it is premature to even think about raising rates. That might make some sense if all this credit was flowing to worthy households and businesses. The evidence, however, suggests that much of it is going toward short-term financial speculation that is great for boosting bank profits and fattening the bonuses of Wall Street wise guys -- but lousy at producing sustainable long-term growth.

If there is one lesson to be drawn from the recent crisis, surely that is it.


© 2009 The Washington Post Company

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