This column has since 2000 been calling for the Federal Reserve to institute a policy of much tighter money. In a sense, events since August have justified it; old fashioned consumer price inflation hasn’t reappeared, but the beginnings of a gigantic global asset price deflation are appearing. At this point, sudden adoption of the Bear’s Lair monetary policy, which would involve a Federal Funds rate in the 8-10% range, would cause a collapse in confidence and very likely a repeat of the United States’ unhappy economic performance in 1931-33. So, given that the Fed is now starting from a place it should never have got to, what is the least painful trajectory from here?
There are two contrary tendencies to be fought. On the one hand, the housing market continues to melt down – house prices nationwide dropped 1.5% in last month alone. That suggests that lower interest rates are needed, in order to increase the affordability of housing for the marginal buyers, and slow the decline in prices. On the other hand, the stock markets have continued strong, and commodity and energy prices have shot up further, producing the specter of $100 oil. That suggests that lower interest rates may actually be making the economic problem worse, transferring all our wealth to unpleasant oil producing regimes.
The ongoing collapse in the subprime mortgage market indicates that the central rationale for interest rate policy has changed since August. If house prices continue to decline as they have in the last year – and there seems currently no reason whatever that they should not continue doing so – then more and more borrowers will find themselves with a larger mortgage liability than the value of their house asset. In itself this does not matter; if employment continues robust and the non-housing sectors of the economy continue to expand, then most of those borrowers will be able to continue making their mortgage payments. Eventually house prices will recover, or their outstanding mortgage balance will decline, and they will once more find themselves in a net asset position.
This would indicate that easy money was appropriate, but there are three problems with this. First, the decline in net worth among homeowners is likely to produce a negative “wealth effect” which will cut consumption and push the US economy into recession. Second, in reducing short term interest rates, the Fed may be “pushing on a string” and find itself unable to reduce the mortgage rates it is attempting to affect. Third, it risks reigniting inflation and it makes further rises in commodity and energy prices almost certain.
The opposite policy, of raising interest rates, would clearly now be damaging if carried out to extremes. Liquidity is disappearing from the US money market, as structured investment vehicles are wound down and taken back onto bank balance sheets. The reduction of $400 billion in asset backed commercial paper outstanding since August is only one example of this. A sharp rise in interest rates runs the risk of a deflationary spiral of collapsing money supply such as occurred in the US in 1931-33, as bank after bank failed.
Fed Chairman Ben Bernanke and the Federal Open Market Committee on December 11 seem likely to pursue their recent policy of a mild easing of money, lowering the Federal Funds rate by 0.25% or so. This will have little effect on house prices, or on the availability of home mortgages. Both need to stabilize at much lower levels before the market clears. It will not lower rates in money markets as a whole; the London Interbank Offered Rate is currently trading at a thumping premium to the Federal Funds rate and will continue to do so. It will also not lower US fixed rates; the 10year Treasury bond is currently trading at a yield around of 4%, close to its historic lows and far below equilibrium real levels given the Fed’s prolonged inability to reduce inflation below the 3-5%-4% range. It will however inject yet more liquidity into the world economy, which will force up the price of equities and other non-housing assets, as well as commodity prices and inflation in general.
This is undoubtedly what Wall Street wants; it is also likely to be largely satisfactory to Bernanke. Only one Fed Chairman has lost his job through keeping interest rates too low – the unlucky G. William Miller in 1979. However in Miller’s time inflation had already established a firm grip. Bernanke may reasonably feel that inflation remains sufficiently subdued that the problem can be ignored at least until after the 2008 election, now only 11 months away.
The dangers of a sharp rise in the Federal Funds rate do not apply to the modified policy of a mild rise in the rate, maybe to 6% in three steps between now and March. While this would make little difference to the housing market or to long term interest rates, it would deflate world stock markets and begin to mop up the excess liquidity that has distorted the world economy over the last decade. The private equity market would remain quiescent, hedge funds would find themselves generally loss-making, and the major US banks that have excessive exposure to subprime mortgages and other “Level 3” assets would be forced to come to terms with reality and start cleaning up their balance sheets.
More important, commodity and energy prices would start to deflate. If asked which would be most damaging to the US economy: an oil price of $120 combined with a Federal Funds rate of 3% or an oil price of $60 combined with a Federal Funds rate of 6%, almost all economists, even those wholly uncommitted to the Bear’s Lair worldview, would confirm that the former combination is likely to be much more damaging. The US payments deficit would be exacerbated, increasing the probability of a catastrophic decline in the dollar, while huge amounts of US consumer wealth would be diverted into the pockets of oil producing countries. These would either like Venezuela, Russia and Iran spend it on enhancing their dreams of world conquest or like Saudi Arabia, most of the Gulf States, Norway and Canada, save much of the increase, investing it in foreign exchange reserves and “rainy day funds” in general.
As Maynard Keynes would have triumphantly pointed out (even a blind pig finds a truffle occasionally) the compulsive savers are much more damaging to the world economy than the megalomaniacs, provided the maniacs don’t succeed. History has proven time and again that madmen with dreams of world conquest are thoroughly stimulative to economic activity, provided they are not permitted to achieve their goals. On the other hand a further increase in the world’s savings rate, producing an additional “glut” of savings in sovereign wealth funds while impoverishing US, European and Japanese consumers, is likely to produce world recession in fairly short order, however stimulating it would be to asset prices and deal flow in the meantime.
But this choice between cheap money and even higher oil and commodity prices or moderately expensive money and oil and commodity prices deflated towards their normal levels is surely what we are faced with. A decline in the Federal Funds rate from 5.25% to 4.5% has produced a surge in the world oil price from about $70 in August to over $90. A further decline in the Federal Funds rate would cause a surge in world liquidity and a weakening of confidence in the dollar, which together would cause oil prices to soar. Extrapolating from the trend since August, a 3% Federal Funds rate, perhaps in spring 2008, would be likely to lead to an oil price around $120 per barrel. Other commodity prices would likewise surge, gold would soar well over $1,000 and the euro would rise strongly against the dollar to above $1.60. I doubt very much whether Treasury bond yields would decline significantly, so the housing market would be largely unaffected and US house prices would continue to decline, with further consumers forced into mortgage difficulties by the rise in their costs of gasoline and heating oil.
Such an economy would be even more distorted than the current one. Essentially Bernanke would have provided yet more inflation for the world economic bubble, achieving little if any progress towards his goals of US economic recovery and house price stabilization, but ensuring a most unpleasant long term denouement. Chinese and US stocks would have risen further, more major companies would have been sold to sovereign wealth funds and more of America’s wealth would have been diverted from Main Street to Wall Street and through Wall Street to the Middle East.
Conversely, a reversal of policy, raising the Federal Funds rate back to 5% on Tuesday, and announcing a goal, absent clear signs of a major downturn of raising it further to 6% within the next few months, would have the opposite effect. The monetary tightening would be far too small to affect the ongoing downturn in housing – in any case long term bond rates would be little affected. However oil prices would begin subsiding to their long term equilibrium level, probably now in the $50-60 range. That would reduce US consumers’ energy bills, giving them additional purchasing power to remain current on their mortgage payments.
This tighter money policy would strengthen the dollar, reducing the economic imbalances that a weak dollar has produced and increasing the willingness of central banks and other foreign investors to hold dollars. It would begin the messy process of deflation in the US, Chinese and other stock markets, bringing on the necessary price correction, but limiting the amount of innocent money that would be lost in a major crash. It would reduce the resources available to Russia, Venezuela and Iran, immeasurably improving the world political environment and stabilizing wobbly “domino” political situations such as Ukraine, Colombia and Iraq. In the long run, it would produce a smaller and less painful US and global downturn, and would increase long term US wealth, as well as beginning the necessary rebalancing of wealth distribution between the overstuffed of Wall Street and the under-rewarded blue collar class.
The chance of Bernanke pursing this superior alternative? Approximately zero!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)