Bernanke hits the joy
button By Julian Delasantellis
In the hospital with my fractured foot
this month, I was introduced to the medical
miracle called Patient Controlled Anesthesia
(PCA). Basically, PCA describes a container of
pain medication attached to the intravenous line,
controlled by the patient himself through a thumb
switch. The doctor would set an upper limit of
analgesia I could self administer per given time
period, after which, no matter how many times you
pressed your joy button, nothing would come out. I
do not believe that the creators of PCA should
receive a nomination for the Nobel Prize in
Medicine, for the Nobel Peace Prize seems much
more appropriate.
And now we have US
Federal Reserve chairman Ben Bernanke, whaling
away at his joy button, rapidly approaching his upper
limit.
For the sixth time since last August, and,
more amazingly, for the second time in nine days,
the US Federal Reserve has decreed another sharp
cut in short-term interest rates, this time twin
50 point cuts of the Discount Rate, to 3.5%, and
the Federal Funds Target Rate, to 3%. Less than
one month into the new year, the Fed has already
engineered a quantity of interest rate easings,
125 points, that only the most optimistic of Fed
observers predicted for the whole year.
I
remember that after the great equity market crash
of 1987, a floor trader was asked about how long
the selling could last. Well, he said, the market
lost 22% of its value that day, so, at the
maximum, this could only last a bit over three
more days.
Just as stock prices can't move
below zero, there is an implicit floor past which
short-term interest rates can't be lowered, and
the United States is currently falling towards
that level like a piano thrown out of a
skyscraper.
At the most basic level,
interest rates are simply the price of money, the
added remuneration a borrower must pay to someone
else, the lender, to convince him that its worth
his while to defer some consumption for the period
of time which is the term of the loan.
As
national macroeconomic managers have realized
since at least the time of Hammurabi (and that was
thousands of years ago), interest rate levels are
key control tools for a national economy. Interest
rates that are too high, like any high price, tend
to depress and inhibit demand; in the case of
investment, their high costs inhibit otherwise
profitable investments that with lower rates would
have been made.
Children at a toy store
learn quickly about how unpleasant it is when
things are priced too high, but, for an economy as
a whole, it's just as bad or worse when things are
priced too low.
Every once in a while, a
radio station, say, Hot Oldies 97.5, will do a
promo and have gasoline sold at 97.5 US cents for
a few hours; the lines of cars around the block
demonstrate the manner in which low prices
stimulate demand.
In the case of money,
its price, its interest rate, serves to interpret
and implement a market economy's desires as to
what projects will or will not receive investment.
Too low interest rates, and investments get made
that would not, and probably should not. As the
manhunt for the perpetrators of the subprime
crisis develops and intensifies, many are pointing
fingers at former Federal Reserve chairman Alan
Greenspan, for dropping and holding the Federal
Funds Target Rate to 1% from mid-2003 to mid-2004.
By lowering the price of investment
capital to near zero, this is said to have spurred
the tremendous overinvestment in the US housing
sector. The massive wave of condominium and
single-family residence construction that followed
defined the froth of the 2004-06 housing mania,
and, as many of these projects now sit empty,
boarded up and in foreclosure, their very presence
signifies the waste of society's scarce capital
that went to build them, not to mention the
devastated fortunes and futures of those who owned
or lent to them.
But what if the Fed
lowers interest rates to the cellar, and still you
don't get a spur in investment and economic
growth? That has been the experience of Japan for
coming on 15 years now. In September 1995, in
response to the collapse of the "bubble economy",
the massive overinvestment in Japanese stocks and
real estate, (that sounds familiar, doesn't it?)
the Bank of Japan lowered its discount rate to
under 1%, where it has been ever since. (It sat at
an unbelievably low 0.1% from late 2001 until last
year.)
Still, the response, in terms of
Japanese economic growth during this period, has
been, at the most, lackluster. This has been due
to capital flight and the fact that low interest
rates may be a very ineffective policy implement
in dealing with economic slowdowns arising out of
crises from an over-leveraged financial sector.
That, too, sounds familiar, doesn't it?
One danger of rapid Federal Reserve
easings down towards 1% that doesn't get as much
attention as it should is the psychological
effect.
An economy in crisis is like a
building afire. If it's your building, nothing
sounds more reassuring than the wails of the fire
engines as they wind their way through the streets
to you. Likewise, as the economic news grows
ever-more grim (as illustrated by the shockingly
low 0.6% growth rate, barely above that which
signifies the onset of recession, for the US
economy reported Wednesday on morning) business
and investors will expect, and receive hope from,
more help from the Fed in the future.
If
the Fed continues to cut at a rate of 125 points a
month, all possible help will be exhausted before
spring; a little slower rate of easings does
essentially the same by mid-summer.
It is
a near certainty that there will still be more
grim economic news (such as the bad news with the
bond insurers that pricked the brief bubble of the
stock market rally that followed on the Fed
decision) hitting the markets by the time the
simple mathematical fact that you can't cut
interest rates beyond zero completes the Fed's
actions.
Far from providing soothing and
immediate relief, central bank interest rate moves
act with a substantial delay, a time lag, as they
work their way through the economy. This time lag
can be at least six months to sometimes as much as
two years. Thus, as the Fed commenced the current
easing rate cycle during last August's financial
crises, the economy was still feeling the
contractionary effects of the interest rate hike
cycle that finished in June, 2006. It will
probably not be until early to mid-2009 that
America will see any positive effects from this
current wave of easings - assuming that the
economy does not settle into a Japan-style
contraction seemingly impervious to monetary
management.
A common complaint regarding
US monetary policy over the past two decades or so
is that, with the wisdom of 20-20 hindsight, the
last move of any interest rate change cycle is
always a mistake.
Greenspan's Fed was
cutting rates (to support the flagging re-election
prospects of George H W Bush, perhaps?) almost
right up to the election of 1992; later it would
be discovered that the economy was in full
recovery almost a year earlier. Greenspan was also
still raising rates well into 2000, as the economy
was starting to deflate from the popping of the
dot-com stock bubble. More recently, Greenspan's
last cut of 2003 stoked the housing bubble, which
Bernanke's final hike of 2006 definitively killed
off.
So, if Bernanke drives rates to 1% or
lower, will it be seen by the beginning of the
next decade as the chief contributing factor to
the development of another ultimately destructive
boom-bust cycle in the economy? With the current
doleful experience with real estate and the
subprimes still a very malodorous sensation in the
nostrils of high finance, the next bubble will
likely not be in housing; in this month Harper's,
Eric Janszen suggests that loans to the renewable
energy equipment and infrastructure sector might
be the next financial crises that will be the
inevitable result of a free market uber
alles government ethic that regulates personal
pet ownership more stringently than it does its
financial markets.
Greenspan dealt with
the time lag problem of monetary policy with the
slow and steady approach; most of his rate moves
were no greater than 25 basis points at a time. In
that way, even if the Fed was doing what later
would come to be seen as damage by cutting or
raising one too many times, at least the damage
might be contained.
Bernanke seems to have
eschewed this approach; of his now six interest
rate easings, four, the August 17 discount rate
cut, the twin September 18 discount and Federal
Funds rates cuts, and both of this month's cuts,
have been 50 points or greater. This is the case
even with many still potentially troubling
indicators of future rising prices. These include
a falling US dollar, and both high energy prices
and sharply rising import prices presenting a very
real argument that inflation continues to be a
real threat to the US economy.
But like a
young man who vows to be not like his father but
soon finds out that the vicissitudes of adulthood
have him making the exact same life choices as his
progenitor, in one way Bernanke now finds himself
walking in pere Greenspan's shoes.
As I explained in October (Reaping what is sown,
Asia Times Online, October 6, 2007), in a review
of Greenspan's autobiography The Age of
Turbulence, Greenspan was always quick to cut
short-term interest rates in times of crisis or
panic in the financial markets; eventually, it
came to be seen that his Fed was reacting to the
markets, rather than the other way around.
With the current cut cycle commenced last
autumn, Bernanke seemed to be going out of his way
to impress on the markets his desire that his
Federal Reserve would follow a new course, that it
would not be led around by the markets. I
explained last November (Bernanke: Don't take me for granted,
boys, Asia Times Online, November 2,
2007, and Playing 'chicken' with the
markets, Asia Times Online, November
17, 2007) I explained how he seemed to be
indicating to the markets that, in the future,
interest rate hikes, and especially cuts, would
now be more closely aligned to changes in standard
macroeconomic variables, such as the outlook for
inflation or unemployment. Markets may rise or
fall as may be, but it's not really a proper
concern for a central bank.
Then came the
stock market declines of November and the past few
weeks. Suddenly, there Bernanke is, a chip off the
old block, taking after his old da, cutting rates
in reaction to market panic. The first line in the
explanatory statement that followed the
announcement of these cuts was: "Financial markets
remain under considerable stress, and credit has
tightened further for some businesses and
households."
But not only is the current
Fed cutting in the face of the financial market's
"considerable stress", they're turbo-cutting,
cutting fast, frequently, substantially, even, as
in both last August and last week, in between
meetings.
In a little-noticed speech from
January 11, Federal Reserve governor and believed
Bernanke Fed board ally Frederic S Mishkin
described the new, pedal to the metal Fed-cutting
paradigm.
Policymakers should be prepared for
decisive action in response to financial
disruptions. In such circumstances, the most
likely outcome - referred to as the modal
forecast - for the economy may be fairly benign,
but there may be a significant risk of more
severe adverse outcomes. In such circumstances,
the central bank may prefer to take out
insurance by easing the stance of policy further
than if the distribution of probable outcomes
were perceived as fairly symmetric around the
modal forecast.
In English, this ain't
your father's Federal Reserve anymore. We're gonna
cut and cut (as illustrated by new market
predictions of further interest rate cuts for next
month and beyond), and the monetary policy time
lag be dammed; if we overshoot and a new boom-bust
cycle develops, well ...
As in the old
Chinese proverb and curse goes - may you live in
interesting times.
Why does the Fed do it
- why do they keep cutting rates on the markets'
command instead of waiting for the time lag to cut
in? As I wrote last summer as the cries for Fed
easings began to mount, the current structure of
the socio-political and socio-economic power
nexuses of America reacts with absolute outrage to
falling stock prices.
Poor children can
snack on lead paint chips in schools redolent of
overflowing sewerage, and through the night
ambulances can crisscross the streets of America's
great metropolises looking for emergency rooms
that will accept a patient in cardiac arrest
without health insurance, but if stocks go down,
the panic buttons really get pushed, especially
with a newsmedia so longing to report the stories
that the critical upper-income demographic finds
interesting and appealing.
But as the
quick selloff that followed the latest rate easing
proved, the path of least resistance in US, and
most likely global, stocks still is down, and, at
this rate, there soon will be little or nothing
that the Bernanke Fed can do about it.
A
common scenario of US television advertisements
features an adult son turning to his father for
advice; if Bernanke is soon forced to turn to Papa
Greenspan for such wisdom, the scene should also
probably include the mobs of rampaging
upper-income stock investors, perhaps armed with
pricey pitchforks freshly purchased from that oh
so chic Restoration Hardware, all baying for his
blood.
Julian Delasantellis is a
management consultant, private investor and
educator in international business in the US state
of Washington. He can be reached at
juliandelasantellis@yahoo.com.
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