Wednesday, December 16, 2015

The Fed Finally Moves

Now that Janet Yellen and the Fed have finally gotten off the floor, it's time to review a brief history of Fed tinkering and its consequences.

Below is the Fed Funds Target Rates for the last 15 years.  (2010 -2015 = 0.0%)

During the period 2001 - 2004 the Fed lowered rates eventually down to 1% to boost a sagging economy and in response to 9/11.  This had an important side effect.  The already emerging housing bubble got a massive new injection of easy money.  The housing bubble was originated by alternative government mortgage policies dating back to the 1990s which upended thousands of years of sound lending practices.  This included mandates for Fannie and Freddie to buy the bulk of the new alternative mortgages.  Then came the Fed.  By lowering rates to historically low levels, the housing bubble was put on steroids.  Along with all the new easy Fed money came the mortgage derivative monster that Hollywood loves to focus on.  This was how the bubble got so big and so dangerous. Fed tinkering, no matter how well-meaning, played a big role.  But the real damage came when the Fed violently burst the bubble it helped create.        

Ben Bernanke became Fed Chairman February 1, 2006 when the Fed Target rate had already been raised by Alan Greenspan to 4.25% from 1%. The day Bernanke became Chairman, he raised the Target Rate to 4.5%, but he didn’t stop there. He kept raising until July 1, 2006 when the Fed Funds Target hit 5.25%. So from July 1, 2004 to July 1, 2006 the Fed raised it’s Target Rate from 1.00% to 5.25%, an increase of 425% in 24 months.

Imagine if food or gasoline went up by 425.00%! Can you picture the carnage?

What effect did all those rate increases have on the yield curve and why would that matter? Well, as most economists will tell you, nothing screams recession quite like an inverted yield curve (when long term rates are lower than short term rates).  Forcing a negative yield curve is economic poison.

In January, just before Bernanke became Chairman, the yield curve was essentially flat with a slightly positive bias, but that quickly changed. Bernanke’s first raise to 4.5%, resulted in a slightly negative yield curve and again, he kept raising the Fed Target all the way to 5.25% by July 1, 2006. By November 2006, there was a clear downward trend in yields. (see chart below).

Why did Bernanke's Fed keep raising interest rates in the midst of a housing bubble with a midterm election coming up in November 2006 and a yield curve already threatening negative by late 2005? Why did they persist and force the yield curve decidedly negative by mid 2006 thus throwing us into recession and crashing the housing market?  Only they know, but their tinkering turned a bubble into a financial crisis.  

The collapse of the housing market quickly inspired the Fed to lower once again - all the way down to zero this time.  That's where it's been for about seven years.  No President in Fed history has enjoyed an economy for his entire term boosted by 0.0% Fed funds rates as has Barack Obama.  So what side effects are we experiencing this time?

That's the funny thing about interest rates; the side effects of Fed tinkering only reveal themselves over time.  Consider this:  During the Obama presidency we have been able to borrow and print over $12 trillion including QEI, II, and III - more than every other U.S. president - combined!  We have financed that spending spree with cheap money that will not last.  When rates normalize, it will consume the federal budget in a way we have never seen before.  This government borrowing bubble will make the housing bubble seem like small potatoes in comparison.

Janet Yellen and Barack Obama hope they will be long gone when that happens.    




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