The Fed As Foe

By Duru

October 3, 2005

I have heard it said that the Fed raises rates until the next financial crisis forces them to start lowering them again. Folks will argue until they are blue in the face whether the Fed exacerbates economic cycles or whether the Fed acts as a moderating force. What has remained true throughout the short history of the Fed is that you cannot fight them and win…at least not until this latest boom and bust cycle. During this latest cycle, the market took much longer than usual to respond in a sustained way to the Fed's aggressive cuts in interest rates. Similarly, the stock market has yet to show sustained downward pull since the Fed began hiking rates in early 2004. As the bond market has continued to defy Greenspan's efforts to raise long-term interest rates, the Fed Chairman has upped the ante on his bubble-bursting rhetoric. Last week, we got another earful from Greenspan warning us that the housing bubble must surely end soon and that those people who continue to assume rates will remain low in the foreseeable future risk substantial losses.

Pay close attention: the Fed has gone from friend to foe. The Fed is, well, fed up, with the continued excessive levels of speculation and risk-taking in the economy, particularly in the housing sector. Sure they themselves sowed the seeds of our destruction with historically low interest rates. Sure Greenspan himself continues to claim that long-term inflation risks are well-contained thus encouraging the long-term bond market to stay put. It does not matter - the Fed is looking skyward, and the yield curve is almost flat across all terms to maturity. Something will have to give way soon. Someone or something will have to back down. Greenspan will give way to a successor early in 2006. Interesting to ponder whether Greenspan is eager to break the back of speculation before he leaves or whether he is content to pass this whole mess along to the next guy or woman. I suspect that he has run out of time to push us into the next crisis, but who knows what lurks in these mile-high deficits, aggressive hedge funds, high energy prices, and piles pf consumer debt, right? Some places to look for the first signs of trouble might be in those regions where consumers are already stretched very thin because of housing costs that continue to rapidly out-strip income growth.

Before we close out this dour message of the day, let's take a close look at key statements from Greenspan's speech on September 26, 2005 just in case we have any doubt that the Fed is on the case against speculation now.

First, the Fed's intention to push mortgage rates up rings loud and clear when Greenspan expresses how unusual it is for rates to remain stubbornly low: "This decline in mortgage rates and other long-term interest rates in the context of a concurrent rise in the federal funds rate is without precedent in recent U.S. experience." Should we be surprised if the Fed fights back with equally unprecedented action? Perhaps pushing the inversion of the yield curve beyond any point anyone currently expects?

Greenspan is also very clear that he understands the implications of pushing mortgage rates upward. He recognizes that housing wealth has driven much of recent economic growth and consumer consumption. Greenspan is counting on the "flexibility" in the economy to cope with any dislocations that ensue from the bursting of this boom, but he looks forward to the net effect of increasing savings and reducing consumption and debt (emphasis mine):

"According to data recently developed by Jim Kennedy of the Federal Reserve Board staff, and me, discretionary extraction of home equity accounts for about four-fifths of the rise in home mortgage debt… It is difficult to dismiss the conclusion that a significant amount of consumption is driven by capital gains on some combination of both stocks and residences, with the latter being financed predominantly by home equity extraction… If so, leaving aside the effect of equity prices on consumption, should mortgage interest rates rise or home affordability be further stretched, home turnover and mortgage refinancing cash-outs would decline as would equity extraction and, presumably, consumption expenditure growth. The personal saving rate, accordingly, would rise… Carrying the hypothesis further, imports of consumer goods would surely decline as would those imported intermediate products that support them. And one would assume that the U.S. trade and current account deficits would shrink as well, all else being equal…

How significant and disruptive such adjustments turn out to be is an open question. Nonetheless, as I have pointed out in previous commentary, their economic effect will, to a large extent, depend on the flexibility inherent in our economy. In a highly flexible economy, such as the United States, shocks should be largely absorbed by changes in prices, interest rates, and exchange rates, rather than by wrenching declines in output and employment, a more likely outcome in a less flexible economy."

Greenspan is no longer tentative about calling a bubble a bubble…well, in his own way: "In the United States, signs of froth have clearly emerged in some local markets where home prices seem to have risen to unsustainable levels." The key word here is unsustainable. Consider yourselves warned! This awakening by the Fed has been a longtime coming. Some time ago, Greenspan had claimed that the high transaction costs of buying and selling a home should act as enough friction to prevent excessive speculation in housing. Now, they are finally realizing that these "natural barriers" have been no match for the current speculative frenzy (emphasis mine):

"…in recent years, the pace of turnover of existing homes has quickened. Apparently, a substantial part of the acceleration in turnover reflects the purchase of second homes--mainly for investment or vacation purposes. According to data collected under the Home Mortgage Disclosure Act (HMDA), mortgage originations for second-home purchases rose from 7 percent of total purchase originations in 2000 to twice that at the end of last year. Anecdotal evidence suggests that the share may currently be even higher. Because down payments on second homes appear to be larger, on average, than they are on homes bought for owner occupancy, and because a larger share of second homes appear to be paid for wholly in cash, second homes presumably represent a larger fraction of total purchases than of loan originations, and arguably are at historically unprecedented levels."

Note well that Greenspan once again describes the activity in the housing market in historic terms. Again, consider yourselves warned.

Greenspan's final warning in this speech is done in classic indirect Greenie-speak (emphasis mine):

"Over the past few years, a great deal of attention has focused on the growing range of loan choices available to mortgage borrowers. The menu, as you know, now features a long list of novel mortgage products, not only interest-only mortgages but also mortgages with forty-year amortization schedules and option ARMs, which allow for a limited amount of negative amortization. These products could be cause for some concern both because they expose borrowers to more interest-rate and house-price risk than the standard thirty-year, fixed-rate mortgage and because they are seen as vehicles that enable marginally qualified, highly leveraged borrowers to purchase homes at inflated prices. In the event of widespread cooling in house prices, these borrowers, and the institutions that service them, could be exposed to significant losses."

He does not come out and declare that current levels of more "exotic" debt are too high. Instead, he just says that if you are a marginal borrower or an institution giving away money to such folks, you are currently laying right across the railroad tracks. He does not say the train is bearing down at this very moment, but he does let us know that we should start listening for the whistles and horns. In case the folks skipping along merrily on the margins did not get the hint, the next day Greenspan spoke just about as plainly as he is able at the annual meeting of the National Association for Business Economics:

"A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more-extended time period. But, because people are inherently risk averse, risk premiums cannot decline indefinitely. Whatever the reason for narrowing credit spreads, and they differ from episode to episode, history cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender."

The audience is left to count their own chickens and figure out which ones are at risk. Regardless, it is clear that the Fed is no longer our friend, and it is now ready and willing to sacrifice the late suckers who will be left holding the bubble, uh, bag.

Despite all this stern lecturing, Greenspan, in classic form, ultimately concludes that despite all the aforementioned risks and dangers, all seems well after all. He is still the erstwhile steward of optimism and faith in the monetary system, and he does not disappoint even now. But incredibly enough, the Fed seems to hope that the bubble has become so big that no amount of picking away at it can deflate it to the point that "significant" numbers of people will get hurt:

"In summary, it is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices. In addition, the LTVs for recent homebuyers appear to be lower in those states that have experienced the most explosive run-up in house prices and that, conceivably, could be at risk for the largest price reversal. That said, the situation clearly will require our ongoing scrutiny in the period ahead, lest more adverse trends emerge."

At least Greenspan claims that the Fed will be on the case watching events unfold. One must wonder what the Fed plans to do if "more adverse trends emerge." Will they cut rates if the suffering from a bubble-popping gets too big? Or will they raise rates further if they do not get the cooling in house prices that they clearly expect to happen? In a speech at the annual meeting of the National Association for Business Economics, Greenspan reminds us that whatever the Fed has planned for this "adversity", it is neither proactive nor preventative:

"It is important to remember that most adjustment of a market imbalance is well under way before the imbalance becomes widely identified as a problem. Individual prices, exchange rates, and interest rates, adjust incrementally in real time to restore balance. In contrast, administrative or policy actions that await clear evidence of imbalance are of necessity late… Being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy asset."

Need I even say… "be careful out there!"

© DrDuru, 2005