Does the Fed Care Only for the Street?
Aside from the dollar and long-term bonds, markets rose last week as the Federal Reserve demonstrated that it is more fearful of a slowing economy and banking woes than inflation. In fact, it is willing to sacrifice the dollar to save the banks. Just last month, the Fed was saying that the threat of inflation is just as great as the threat of a slowdown in the economy. Now it is cutting rates in a huge way as the Dow nears its all-time high, gold is making new highs, and the price of oil is exploding.
The Fed is obviously terrified. Chairman Ben Bernanke built his career on a doctoral thesis that claimed that the Fed didn't cut rates fast enough during the 1929 stock market crash. But if you look at a chart of the Depression bear market with an overlay chart of interest rates, you'll see that the Fed cut interest rates as the market topped. And when you look at the charts for a few years later, when the market finally bottomed, you'll see that the Fed had been lowering rates all the way down.
Fast Rate Cuts Forestall Losses
Bernanke believes that the Fed should have cut rates all at once during the start of the bear market instead of gradually over two years. He seems to be putting this belief to work right now. It means that he is gravely concerned about the state of real estate and banking in the U.S.
When Alan Greenspan was at the helm he often had Fed governors write papers to rationalize and justify changes in Federal Reserve policy. For some insight into the Fed’s dramatic cut on Sept. 18, one should read the recent paper by Fed governor Frederic Mishkin, who tweaked a Fed economic model and showed that a 20% decline in home prices could cause consumer spending to drop by 2% within two years, about twice the amount forecast by a previous model. However, Mishkin theorizes that damage could be contained if the Fed acts quickly and dumps rates (BusinessWeek, 9/7/07) before it sees evidence of actual damage, thereby minimizing output losses.
And Mishkin isn't just any Fed governor. He is one of Ben Bernanke's closest friends. The two served at Columbia University together and in 1997 co-authored a book, Inflation Targeting, calling on central banks to make public goals for inflation. Mishkin's views dovetail with Bernanke's.
If the credit markets don't revitalize in the next few weeks, you can expect to see the Fed lower rates again by another 50 points at their October Federal Open Market Committee meeting no matter where the dollar, gold, or the Dow are. They have signaled that they don't give a damn about the dollar. All they care about is Wall Street.
The Case for One Big Cut
However, there's another way to view the matter. One could say that they don't care about inflation because they see a total bust in housing that will create deflationary pressures in the economy. Mishkin's paper projects negative gross domestic product growth for the next five years, a federal funds rate falling two full points lower, consumer spending shrinking for five years, and the consumer price index going down and staying negative if housing prices decline by 20%. These negative trends are expected to begin now and accelerate through 2010.
Mishkin sees such a housing price decline as very likely, given that home prices fell by 16% from late 1979 through late 1982. Contrary to people who believe that real estate is the best investment you can buy because it never drops, remember: It has dropped in the past. And with bubbles leading to busts, it is happening right now. The question remains, when will it stop? After the Nasdaq topped in March, 2000, it didn't bottom for two full years. Real estate topped out a year ago.
According to Mark Zandi, co-founder of Moody's Economy.com (MCO), housing prices will decline by at least 11% in the next three and a half years. Zandi sees prices in New York City falling between 1% and 7% for each of the next five quarters, leaving a lot of leeway in his projections. Hey, if we get only an 11% decline and you cut the Fed model projections in half, we're still facing a horrible recession.
Mishkin argues that "the task for a central bank confronting a bubble is not to stop it but rather to respond quickly after it has burst." Instead of following his models by lowering ratings as economic conditions deteriorate—nearly to the point of a depression—Mishkin advocates cutting rates all at once, just as Bernanke's doctoral thesis argued.
An Untested Theory
I have to wonder what happens if the Fed lowers rates by 1% or more in the next three months and real estate doesn't rebound? A central bank has never tested these theories. We don't know if cutting rates all at once will prevent the damage caused by a bursting bubble. Even when the tech bubble burst in 2000, Alan Greenspan didn't lower rates until almost a year later, after the Nasdaq fell to almost half its value.
The problem is that real estate is still overvalued, just as tech stocks became overvalued in 2000. It's likely real estate will need to return to a normal valuation before it bottoms out, setting the stage for recovery, so simply lowering interest rates may not have the wonderful effects that Mishkin and Bernanke hope for.
What I do know for sure, which is all you need to know to make money, is that the Fed is setting up an inflationary trend. The money the Fed prints has to go somewhere. Of course, this is bullish for gold and commodities—which are now leading the stock market. Still, it's entirely possible that the Dow and broad market could continue to go up, too.