The Fed’s bursting bubbles

In Opinion
Courtesy of MCT
Courtesy of MCT

Politicians and media pundits are joyously extolling the raging bullish stock market and rebounding real estate prices after the Great Recession’s doldrums. Despite this seemingly good news, such developments suggest a series of new bubbles have arisen at the behest of the Federal Reserve’s lax monetary policies and Quantitative Easing (QE) sessions.

This façade of rising prosperity disguises troubling economic imbalances that threaten to topple the country into another economic disaster.

The root of the problem delves from the Fed’s attempts to improve the economy through monetary manipulation. In a bid to inject liquidity into the market, the Fed has created and pumped $3 trillion into the economy through purchases of government treasuries and mortgage backed securities (MBS). The intention and result was to drive down yields on treasuries so investors would pull money from them and into more dangerous but profitable stocks and corporate bonds.

In addition, the mass purchase of MBS’ lowered yields encouraged homebuyers to take out mortgages. With purchases of $85 billion per month until a to-be-determined date, the Fed has embarked on the most interventionist policies in its history.

It has also kept interest rates near zero, allowing member banks to borrow almost “free” money in order to promote private borrowing.  Fed Chairman Ben Bernanke announced that these monetary spigots will only be tamped when the unemployment rate falls to 6.5 percent, or inflation increases to 2.5 percent; the former, if not the latter, a distant prospect.

Unfortunately, such economic manipulation harkens to other boom times that inflated unsustainable bubbles in the housing and stock markets after government policies drove capital into speculative ventures.

After its debilitating reliance on monetary stimulus, the stock market now reacts to politics instead of corporate earnings. In February, the Dow neared its October 2007 zenith of 14,164 while the S&P 500 hit a five-year high on Feb. 1, only two weeks after the shocking announcement that the economy actually shrank in Q4 of 2012. In contrast, two weeks later the market fell sharply after the Fed unexpectedly expressed hesitancy about the wisdom of continued QE.

Instead of stock prices mirroring rising profitability, the booming market has inversely mutated into a cheerleader of economic weakness that guarantees continued monetary pumping; positive economic news even creates a speculative bear market that fears a tightening of the Fed’s QE spigot.

Meanwhile, housing prices have surged 12.3 percent, the number of homes bought and sold has increased by 9 percent and Midwest farmland has shot up 16 percent over the last year, in no small part to the Fed’s policies. However, these policies threaten to re-inflate the housing bubble that initiated the Great Recession and saddle banks with unprofitable ultra-low interest rate mortgages when interest rates inevitably rise and a new wave of foreclosures emerge.

As a further result of the Fed’s QE, corporations are enjoying strong demand for privately issued debt and low interest rates. Over the last year, businesses issued $274 billion in Greek-level speculative grade junk bonds, 55 percent more than the year before and double pre-recession levels. A collapse in that market or overexposure to defaulting bonds could precipitate a new financial crisis. Finally, government treasury yields are also near an all-time low, encouraging borrowing and creating the possibility of a sovereign debt crisis if yields jump.

However, as the Fed’s books grow fatter, a small rebellion has begun against the easy money bonanza.

Esther George, the president of the Federal Reserve Bank of Kansas City, warned that lax monetary policy could create new bubbles and ultimately harm the financial system. She counseled that “A long period of unusually low interest rates is changing investors’ behavior” and a future correction in inflated prices could become “destabilizing and cause employment to swing away from its full-employment level.”

In other words, the Fed’s cheap money is flowing into unsustainable activities which, in a case of monetary tightening or economic trouble, could crumble and result in a renewed tsunami of unemployment.

Fed Bank of Philadelphia president Charles Plosser warned that “Attempts to increase economic ‘stimulus’ may not help speed up the process (of economic recovery) and may actually prolong it” while “the very (lax) accommodative stance of monetary policy in place for more than four years now, (means that) we must guard against the medium and longer-term risks of inflation.”

Eventually, one or more of these bubbles will pop and trillions of dollars worth of paper assets will disappear as prices plummet toward reality. Those left holding the bag of worthless investments and overvalued speculative ventures will be bankrupt, risking another round of bank failures and government bailouts. Most troublingly, this could ignite a currency crisis if the treasury market implodes and the Fed redoubles its asset purchases in an attempt to stem the collapse.

Despite the reassurances from our Washingtonian leaders, central economic planning will never guide this nation down the road of prosperity.

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