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Bernanke's 'Rookie Mistake' Forces Fed to Shift Focus to Market
By Craig Torres
complete article: http://www.bloomberg.com/apps/news?pid=20601087&sid=amXgP4xSCOWU&refer=home
Aug. 20 (Bloomberg) -- Federal Reserve policy makers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.
By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their Aug. 7 meeting. Some economists describe the about- face, coming after months of assurances that the subprime- mortgage rout was contained, as Chairman Ben S. Bernanke's first serious error since taking office last year.
"It was a rookie mistake,'' said Kenneth Thomas, a finance professor at the University of Pennsylvania's Wharton School in Philadelphia. The Fed "underestimated liquidity needs'' of investors and the fallout from the housing recession, he said, adding, "This demonstrates the difference between book-smart and street-smart.''
THE US, in the middle of a housing market meltdown and one of the worst financial shocks in decades, may be heading for a recession, according to a growing number of economists.
Some are calling for US interest rates to be slashed to protect the world's largest economy. It's so serious that some say the US Federal Reserve should enact emergency cuts in the next 48 hours.
But Australia has just increased interest rates, thanks to higher than expected inflation numbers, and the Reserve Bank governor, Glenn Stevens, has implied that interest rates might need to go higher yet.
It appears Stevens's stance on interest rates is at odds with conventional wisdom: if the RBA is right, the US is an economy slowing down but we are still speeding up.
The adage was, the US sneezed, the world caught a cold. Even the past week appeared to prove that, as global stock markets were sent into a tailspin despite a problem that was homegrown in the US.
But Stevens, while saying he was eyeing the US housing market meltdown cautiously, was taking a bet that the US might slow down but the rest of the world would continue to pick up the slack.
Stevens testified to a House of Representatives Committee on the Gold Coast last Friday that the "downside risks to the US economy do appear to have increased over recent months, but in other parts ofthe world the growth outlook has, if anything, been markedly higher recently".
About 12 hours later, the US Federal Reserve released a statement before the opening of trading on Wall Street and shocked the world, announcing that it had radically changed its view on the $US13 trillion ($16.3 trillion) US economy and the risk of a slowdown had dramatically increased. Just the week before, like the RBA, the Fed said inflation was still the main concern (although it did not increase rates then) but in the space of 10 days, things had flipped.
The question now is whether Stevens, whose language on the US economic scene has been right out of the Fed play book, is also about to change his tune.
Central bankers, particularly Fed chairman Ben Bernanke, have been slow to see the danger the mess in the US mortgage market posed, despite warnings for more than 12 months that it was a ticking time bomb.
While there are plenty of boosters in the US continuing to talk up the economy, the blow to confidence there should not be underestimated.
And if data over the next two months proves the pessimists right on a US recession -- rated by some at a 25 per cent chance, by others as an inevitability -- Stevens's interest rate hike two weeks ago and his hawkish stance will have to be quickly reversed.
Mark Zandi, the chief economist at Moodys Economy.com, who has been warning since at least mid-last year of the threats to the US economy, said Bernanke "needs to be very aggressive" in cutting the benchmark Federal funds rate of 5.25 per cent by as much as 50 basis points "if financial markets don't stabilise in the next few trading days".
"Investor fears are infecting the psyches of consumers and businesses and the odds of recession are rising quickly as a crisis of confidence could undermine the economy's still good, but now weakening, fundamentals," he said.
Zandi said the US housing crisis would start to hit consumer spending.
"Lower housing values and stock prices will hurt, as will the higher cost of credit for everything from an auto loan to a credit card," he said.
Michael Metz, chief investment strategist at New York financial house Oppenheimer & Co, added: "The course is set for a consumer-led recession by early next year, and recent Fed moves do not change this prospect."
So does conventional wisdom still apply -- will Australia sink with the US too, despite the rise of China and others?
"If the US catches a cold, the rest of the world will get sick too, but to varying degrees," says Stephen Walters, chief economist at JP Morgan Australia. He said that while Australia was tied more to Asia than elsewhere as an export destination, growth in Asia would falter in the event of a US slowdown and "so we will suffer".
If America slips into recession, however, all bets are off.
Crack addict? Hyperbolic "nonsense." There has been very little inflation over the past decade and no reason for interest rates to be high. Artificially high rates would have unnecessarily inhibited economic growth. Is that what you wanted? Under Greenspan's leadership the stock market eventually recovered after 911, and GDP consistently increased, while simultaneously the US consumer engine continued to drive world economic growth. All of which occurred despite rising energy prices. You cannot get a much better result than that; especially in light of the ridiculous spending behavior of the Bush Administration. Obviously it would have been better to not have blown half a trillion in Iraq, but that was not Greenspan's fault. You may not like Greenspan, but it cannot be because of his results, and his international reputation is unsurpassed. When I lived in Asia, from 2001-3, many people in China, Japan, and Korea thought of Greenspan as literally the smartest person in America.Alan Greenspan is making $100k a speech and watching his successor deal with the mess he made.
I disagree with the assessment that Bernanke made a "rookie" mistake. That's nonsense.
The problem is that Easy Al got the market addicted to rate cuts like a crack addict. His actions encouraged excessive risk taking because he instilled a belief in investors that the Fed will always be there to bail them out. Now, today you have over-leveraged hedge funds speculating in garbage paper that is worthless, which has caused a seizure in inter-bank and money markets.
Bernanke is attempting, amongst other things, to re-establish a more appropriate risk premium in financial markets, one that has been sorely lacking until recently.
Crack addict? Hyperbolic "nonsense." There has been very little inflation over the past decade and no reason for interest rates to be high. Artificially high rates would have unnecessarily inhibited economic growth. Is that what you wanted? Under Greenspan's leadership the stock market eventually recovered after 911, and GDP consistently increased, while simultaneously the US consumer engine continued to drive world economic growth. All of which occurred despite rising energy prices. You cannot get a much better result than that; especially in light of the ridiculous spending behavior of the Bush Administration. Obviously it would have been better to not have blown half a trillion in Iraq, but that was not Greenspan's fault. You may not like Greenspan, but it cannot be because of his results, and his international reputation is unsurpassed. When I lived in Asia, from 2001-3, many people in China, Japan, and Korea thought of Greenspan as literally the smartest person in America.
Perhaps if he had allowed the initial correction of the markets to last a little longer than he did, we would be in less of a mess than we are today. Just a thought.
Crack addict? Hyperbolic "nonsense." There has been very little inflation over the past decade and no reason for interest rates to be high. Artificially high rates would have unnecessarily inhibited economic growth. Is that what you wanted? Under Greenspan's leadership the stock market eventually recovered after 911, and GDP consistently increased, while simultaneously the US consumer engine continued to drive world economic growth. All of which occurred despite rising energy prices. You cannot get a much better result than that; especially in light of the ridiculous spending behavior of the Bush Administration. Obviously it would have been better to not have blown half a trillion in Iraq, but that was not Greenspan's fault. You may not like Greenspan, but it cannot be because of his results, and his international reputation is unsurpassed. When I lived in Asia, from 2001-3, many people in China, Japan, and Korea thought of Greenspan as literally the smartest person in America.
You say there is little inflation. There is little consumer price inflation - if you believe the official statistics. Greenspan legitimized the concept of "core" inflation, which excludes food and energy prices. Do you pay more for gas than you did five years ago? What about food? But that doesn't count in the Fed's focus on "core" inflation. Also, during Greenspan's tenure, the Fed changed the measurement of housing costs by measuring it as "implied rent", which is a function of interest rates. So while housing costs were rising 10% a year for five years, the Fed's "implied" housing costs rose 1-2% per year. Do you really believe that housing costs have only risen 2% this decade? Yet energy, food and housing account for ~40% of the CPI. No inflation indeed.
But inflation is not the readings of an index of consumer prices. Inflation is the creation of money at a rate faster than the rate of economic growth. Consumer prices are an outcome, but it is only one possible outcome. Inflation also manifests itself in asset prices, which is the primary inflation of today. It is a folly of the central banks of our time to focus only, or primarily, on consumer prices as an index of inflation, and Greenspan was particularly guilty of this.
In our time, the excess creation of money has not filtered into consumer prices, which is as much a lucky accident for Greenspan's experiment as anything. The inclusion of China and rapid technological advancement the past 10 years has had the effect of holding down consumer prices. With such exogenous factors, that excess creation of money has filtered into global asset prices. Have you ever wondered why the price of housing has skyrocketed on virtually every place on the planet? Look no further than too much money in the world. How about the price of gold going from $250 to $750 in 7 years? Do you think that is accident. Stocks, bonds, real estate, gold, silver, commodities, art, wine, etc., all of it has risen at rates sometime 2, 3, 4 or even 6 standard deviations away from the norm.
Why does that matter? Because distorted asset prices create misallocations of capital, which has effects in the real economy. By chance do you live in Silicon Valley? The severe distortions of capital eventually caused a depression in the teleconomy and wiped out hundreds of billions of dollars in savings.
You see the after-effects of too much liquidity in capital markets today. The subprime mess is at least partially a result of too much money in the world. Too much credit lead to too many houses being built, and now you have a calamitous event occurring in the housing market, which is nowhere near finished.
Many people believe Greenspan to be a great central banker. But many others do not. Jim Rogers has described him as "the most incompetent central banker of all time." I think that is harsh as I believe not all the problems in the world today are the result of his problems. But he certainly exacerbated them. And as we head into a recession and as housing prices continue to fall and financial companies blow up, he bares some responsibility.
You quote this unbelievably biased pal of George Soros as a credible source on Alan Greenspan? Not only is his appraisal harsh, it is flat out wrong and may be politically motivated. Please, at least characterize you citations, most people have no idea who Rogers is, or that he is deeply connected to Soros.Many people believe Greenspan to be a great central banker. But many others do not. Jim Rogers has described him as "the most incompetent central banker of all time." I think that is harsh as I believe not all the problems in the world today are the result of his problems. But he certainly exacerbated them. And as we head into a recession and as housing prices continue to fall and financial companies blow up, he bares some responsibility.
You quote this unbelievably biased pal of George Soros as a credible source on Alan Greenspan? Not only is his appraisal harsh, it is flat out wrong and may be politically motivated. Please, at least characterize you citations, most people have no idea who Rogers is, or that he is deeply connected to Soros.
Why does that matter? Because distorted asset prices create misallocations of capital, which has effects in the real economy. By chance do you live in Silicon Valley? The severe distortions of capital eventually caused a depression in the teleconomy and wiped out hundreds of billions of dollars in savings.
Toro, would you happen to have some articles handy which explain the whole misallocation of capital thing, and how fed bungling under Greenspan caused it? I'm specifically looking for articles from people who are not for a gold standard or for abolishing the federal reserve, so no austrians. I was arguing against one guy on another forum who seemed bewildered and angered at the very premise that fed bungling can distort markets. He even posted some article by Krugman where Mr. Krugman dismisses the idea of misallocated capital (I believe he called it "hangover theory" or "overinvestment theory" or something) causing economic pain. He also seems to think that it's uniquely an austrian theory, but it isn't...uhh right?
Your citing the opinion of someone as an authority who is deeply connected with George Soros is the joke. Gee, what was the opinion of Alan Greenspan on Air America? They have as much credibility as Rogers. Your first two citations immediately above did not even mention Greenspan, and for every apocalyptic hedge fund manager (what an economic authority) like Fleckenstein you can find another with the opposite opinion. Your posts above, try as they might to discredit the outstanding economic results under Greenspan, cannot refute his record of economic growth with food and energy corrected low inflation. Greenspan cannot be faulted for keeping markets in the US liquid. As soon as the present Fed leadership made money tighter, the markets behaved as anyone would have expected: consumer interest rates increased and those with variable rate mortgages went upside down. What's the mystery? We live in a $14 trillion dollar economy and it is because of Greenspan's leadership, not because of the maladaptive interest rate increases of the current Fed leadership. Ever hear of supply and demand? That is the principle reason real estate prices increased over the past decade. Rent and property prices outside of major metro areas have hardly increased at all. Did the Fed recently reverse course because they were right when they increased rates? Clearly not. And contrary to your implication above, the cost of rent and property are included in the CPI (of which there are at least five different measurements). Only food and energy are typically subtracted in the commonly quoted CPI: commodities that often show temporary volatility unrelated to structural inflation. It is beyond dispute that core inflation remained under control when Greenspan was in command. Ask people with long-term equities investments about the quality of Greenspan's Fed, not those suffering from variable rate blues induced by the current Fed.Is this a joke? What does politics have to do with any of this?
To say that Rogers' opinion is driven by politics is silly if one is paying attention to the economic argument.
Here are others who are critical of Greenspan
Nouriel Roubini
James Grant
Bill Fleckenstein
Tim Iocano
David Tice
etc., etc.
Most of those guys, BTW, are Republicans.
Your citing the opinion of someone as an authority who is deeply connected with George Soros is the joke. Gee, what was the opinion of Alan Greenspan on Air America? They have as much credibility as Rogers. Your first two citations immediately above did not even mention Greenspan, and for every apocalyptic hedge fund manager (what an economic authority) like Fleckenstein you can find another with the opposite opinion.
Your posts above, try as they might to discredit the outstanding economic results under Greenspan, cannot refute his record of economic growth with food and energy corrected low inflation.
Greenspan cannot be faulted for keeping markets in the US liquid.
As soon as the present Fed leadership made money tighter, the markets behaved as anyone would have expected: consumer interest rates increased and those with variable rate mortgages went upside down. What's the mystery? We live in a $14 trillion dollar economy and it is because of Greenspan's leadership, not because of the maladaptive interest rate increases of the current Fed leadership. Ever hear of supply and demand? That is the principle reason real estate prices increased over the past decade. Rent and property prices outside of major metro areas have hardly increased at all.
Did the Fed recently reverse course because they were right when they increased rates? Clearly not. And contrary to your implication above, the cost of rent and property are included in the CPI (of which there are at least five different measurements). Only food and energy are typically subtracted in the commonly quoted CPI: commodities that often show temporary volatility unrelated to structural inflation. It is beyond dispute that core inflation remained under control when Greenspan was in command. Ask people with long-term equities investments about the quality of Greenspan's Fed, not those suffering from variable rate blues induced by the current Fed.
Most of the goods and services I consume seem to be escalating in price by much more than a percent or two. My tuition bills, health care premiums, insurance costs, transportation and energy costs, home-operating expenses, are all increasing at high-single-digit or maybe even double-digit rates. Home prices in my neighborhood are skyrocketing. As for entertainment, the restaurant check, the movie tickets and the cable bill have all jumped much more than a couple percent. Deflation here? Give me a break.
With my personal inflation experience so much different than government statistics, I decided to research the CPI. Here's what I discovered. First, the government removes food and energy, about 22% of the index, when calculating the core CPI. I guess if you don't eat, drive or heat your home, this would be appropriate.
Next are housing costs. This is the biggie, weighing in at about 40% of the actual CPI and closer to half of the core index. Now, everyone knows that housing prices and operating costs such as insurance and taxes have appreciated strongly in the past few years, something like 5% to 7% annually. Clearly this component must be pushing up the inflation numbers. Well, not really. The government doesn't use housing prices and home-operating costs, but rather a quite interesting concept called rent and owner's equivalent rent.
An overbuilding of apartments and a secular shift toward home ownership have depressed the rental market. About 70% of households own homes today and are not directly impacted by rents. However, the government doesn't revert to actual housing costs here. Instead, it attempts to estimate what homeowners' rent would be if they were renting their primary residence.
But very few single-family homes participate in an active rental market. So, basically, the government makes it up. In the December 2003 CPI report, the total rent component of the CPI (rent plus owner's equivalent rent) rose 2.2%, a 20-year low. Even adjusting for lower financing costs, I have a difficult time believing that 2.2% number, as does my real estate agent.
But it gets even better. When energy prices increase significantly, as they recently have, shelter prices decline. That's because the rent/owner's equivalent rent concept implies a heating/cooling contract. Because actual rent paid is somewhat sticky, rising energy costs decrease the value of the rent component. For example, the housing part of the CPI was up 2.1% in February year over year. But in the core CPI, spiking energy costs lowered the change to 1.6%. With this methodology, $100 for a barrel of oil would turn the rent/OER concept negative in and of itself. How absurd is that?
Jim Grant, proprietor of Grant's Interest Rate Observer, has calculated the CPI substituting a housing price index for owner's equivalent rent. As his chart reveals, inflation is running around 3.5% instead of the 2.2% core number reported by the government. This kind of number seems more accurate to my personal income statement.
It gets even better. The people at the Bureau of Labor Statistics make qualitative adjustments to goods when they perceive improvements. That is, they adjust the base price of a good or service upward due to quality improvements. This action then understates the increase because of price inflation of the good. The BLS does this with more than 50% of the CPI components!
They do not, however, adjust base pricing lower for qualitative deterioration in a product. Steve Leuthold had a great example in a publication recently. Since 1979, the average price of a new car has risen from $6,847 to $27,940, or 308%. But the CPI-adjusted series from the same date reveals only a 71% increase. Therefore, about $16,000 of the $21,000 increase is due to quality improvements and not in price inflation. Ironically, the repair bills aren't deflating. The BLS is now attempting to expand the number of CPI categories adjusted for quality improvement.
