Fed Still Taking the Easy Way Out
By Peter Eavis
Senior Columnist
10/29/2003 07:16 AM EST
The Fed kept money easy Tuesday. Wall Street cheered, debtors piled more on their credit cards, and the president, eyeing next year's election, probably felt like calling Fed Chairman Alan Greenspan to say how much he loves him. Heck, even bond investors seemed to like the move, bidding the 10-year Treasury higher.
But when just about everyone in the nation wants the same thing -- in this case, super-low interest rates -- there has to be a hitch. And when it comes to cheap money, there most certainly is.
The Fed decided to leave its federal funds rate unchanged at 1% -- and used acutely accommodative language to justify its decision. Stock indices moved up sharply when investors saw that the Fed is sticking to its soft stance. The Wall Street view is that the nation's historically low interest rates are uniformly good for companies and individuals. As debt piles higher and higher, so do the Street's hopes for a recovery.
In a statement giving its rationale for not changing rates, the Federal Reserve said its "policy accommodation can be maintained for a considerable period." When any central bank talks about doing something for a "considerable period," it is telling the world that is has no intention of changing its stance any time soon. Stocks leaped after the statement came out.
But the Fed's words actually convey one of two things: fear or recklessness -- characteristics that can destroy the reputation of a nation's central bank. And when the credibility of the central bank crumbles, so do the economy and the stock market.
Fear Itself
First, what is the case for the Fed acting out of fear -- fear that the economy is about to drop back into a hole? With nearly all economic indicators looking healthier, the case of bearishness would seem weak. Detox, for one, doesn't believe the economy is about to grind to a halt.
Third-quarter GDP growth is expected to be as high as 6%, for example. The most credible bears argue that the recent buoyancy is overwhelmingly the result of unsustainable credit creation, particularly in the mortgage market.
What happens, they argue, when mortgage lending, and other types of consumer credit, slow down?
Will we see a nasty slowdown because businesses won't be there to pick up the slack? Dark thoughts, and a recent money-supply statistic should give the bulls pause. Money supply correlates nicely with GDP growth. And, somewhat unnervingly, growth in a measure of money supply known as M2 has stopped after month upon month of rapid growth.
In the 13 weeks ended Oct. 13, M2 did not grow at all on an annualized basis, according to Paul Kasriel, chief economist at Northern Trust. But, back in July, M2 was advancing at over 15%, Kasriel notes. The economist expects tax cuts and business borrowing to kick in and help swell M2, but the slowdown in the indicator shows the dysfunctional dependence on mortgage lending and other types of consumer credit.
Greenspan may have seen that M2 slowdown, among other indicators, and thought it best to keep the pedal to the metal. What's wrong with that? This: When a central bank floods the economy with money, it prompts overinvestment in certain sectors and causes inflated prices. The soaring cost of a home in certain regions shows that very clearly.
But the Fed needs inflation. Indeed, it is absolutely petrified by the prospect of deflation. Why? Because of the soaring debt levels on personal balance sheets. Deflation doesn't change how much money a person owes, but it can reduce the value of collateral backing his or her loan. When that happens, defaults soar and banks get crushed.
That is why the Fed, in its Tuesday statement, called a fall in inflation "unwelcome," adding cautious words on "the risk of inflation becoming undesirably low." It created the conditions that created the debt mountain. Greenspan has dragged the nation into a debt trap of his making. His only answer is to print more money, to inflate people out of the trap.
Sector Spotlight
That inflationary stance can be characterized as recklessness. Why? Because markets aren't stupid all the time. As soon as investors see inflation gaining ground, interest rates will skyrocket, forcing defaults. The interest burden on households has never been heavier.
Why won't the economy be able to keep growing when rates rise, pushing up personal income by enough to pay the higher interest costs? Because the economy is actually very unbalanced, despite the appearance of buoyancy. The excess money in circulation leads to overinvestment in certain sectors and underinvestment in others. Distortions become deeper and deeper. When interest rates rise, even by a small amount, the house of cards collapses -- as happened in mid-2000.
Don't believe Detox? Well, look at the way financial companies are behaving. Low interest rates have helped their balance sheets and boosted profits tremendously over the past three years. Now, it would appear, they sense tougher times could be coming because debtors are up to their necks in leverage.
Take Bank of America's (BAC:NYSE) bizarre offer to purchase FleetBoston (FBF:NYSE) at a price-to-earnings ratio that exceeds its own by a huge amount.
Surely, if Bank of America were going to continue growing earnings at a high rate, its multiple would've ticked up as investors bought into the bank's prospects. The strongest explanation for the deal, then, is that Bank of America knows its profits aren't sustainable.
Another sign of financial sector dysfunction is Fannie Mae's (FNM:NYSE) decision to risk further damage to its balance sheet to achieve Wall Street's expectations for earnings growth. Just as maniacal is the loan growth at Capital One (COF:NYSE) , the credit card lender.
The company, regulated by Greenspan's Fed, added $6.5 billion of loans to its total portfolio in the third quarter, an increase of more than 10% from the second quarter. It's not much of an exaggeration to say that the company is single-handedly shoring up the economy. And yet, through all this growth, Capital One is letting its bad-loan reserve drop.
It's hard to imagine any reasonable bank regulator allowing such developments even at a well-managed company. But Capital One is not well managed. Only two years ago, its management led the company into a near cataclysmic foray into loans to people with poor credit histories.
It is amazing that Greenspan would take us this far -- and that Wall Street would still give him the benefit of the doubt. |
