How the Fed Got Itself Boxed In

Yesterday morning’s comments (Random Thoughts: Recent Trading/Market Activity) began with this bullet point:

“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.”

Quite a few people responded, seeking clarification, and so I wanted to briefly address this issue.

The Federal Reserve (unlike most other central banks) has a dual mandate: Maintain full employment and keep inflation at bay. History informs us that these two factors are often opposed to each other: Growth begets price rises, and excessive price elevation retards growth.

Hence, for the Fed to do its job well, they have a neat balancing trick to perform.

We can trace the origin of the current Fed situation to a drift away from those two mandates. This occurred sometime in the 1990s, when then FOMC chair Alan Greenspan somehow began focusing on markets, asset pricing and a nonsensical catchall “investor confidence.”

It wasn’t long after that when traders deduced that the Greenspan was their bitch. It soon became apparent that at the first sign of trouble, the Fed stood ready to flood the system with liquidity. In just 4 short years, markets saw the Fed respond massively to the Asian Contagion (1997), Russian bond default, Long Term Capital Management Collapse (1998), Y2K bug (1999), Dot Com implosion (2000), 9/11 (2001).

There was no small irony in that Greenspan, Mr. Free Market himself, had become Mr. Centrally Planned Economy. This was not lost on the Wall Street community, whose jobs were to figure our where the best and most lucrative opportunity lay. Liquidity driven asset prices was the answer to that question.

Following the Y2K cash infusion on October 22, 1999, the Nasdaq doubled from 2500 to 5100 over the next 6 months. The 78% collapse it suffered overstates what should have been a more typical 50% crash (lets call it 2500 down to 1250) had the Fed intervention not occurred.

With the Fed Funds rate at 6% in late 2000, the Fed began slashing rates in January 2001. They made 8 rate moves between January and August 2001, cutting rates in half to 3%. Note this was all prior to 9/11. I believe Greenspan panicked, taking rates all the way down to 1.25% following the attacks.

At the time, it was unprecedented to have rates below 2% for three years, and at 1% for a year.

The net results of this action were enormous. Bond managers scrambled for yield, ultimately finding AAA rated mortgage backed junk product. The dollar plummeted 41% over the next 7 years. Anything priced in dollars skyrocketed, and inflation went screaming higher. Housing took off, loan standards collapsed, credit quality suffered.

There were many other factors involved: Radical deregulation, Globalization, diminishing incomes, labor restructuring.

But imagine what might have been if the 1990s/early 2000s Fed had been more circumspect. 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 DotCom collapse should have led to a flushing out recession and market crash that took a few years to recover from.

Instead, the Fed gave us a hair of the dog that bit us: More cheap money, and another liquidity driven rally.

Many of the subsequent ills this economy has suffered through derive from those decisions a decade or more ago. They have certainly been compounded by a variety of other really bad calls. But much of this traces itself back to the Greenspan Fed.

There is a reason I noted How easy money corrupted Wall Street and shook the world economy — it was a prime spark to the conflagration. Had we had a more normalized Fed policy, much of what took place in the 2000s very well would have gone down quite differently. We would likely have had a deeper, more painful recession, but we would have been on 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 are alcoholics.

Hence, yesterday’s Fed announcement is the product of these earlier errors. The Fed cannot raise rates, lest they cause another recession. And the Fed cannot keep rates here, lest they admit their own policy failures, debase the currency further, and send oil over $100 and gold towards $2500.

They are boxed in. And they have no one to blame but themselves . . .

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