Friday, November 6, 2009

Bernanke & Co. Have Their Hands Full

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

As I begin to write this, the Federal Reserve just announced that the Fed Funds rate (short-term interest rates) will remain as is, in the range of 0% to .25% for an extended period. It’s the same message Bernanke & Co. have sent for almost the past year. Borrowing is essentially free to banks as Japan did for years and years and years, hoping to stimulate loan demand, money velocity and credit growth. As you may know, it’s been 20 years of poor economic growth and deflation in Japan with no end in sight. They are an aging and non growing population with a dim future.

While I totally agree with the Fed on their interest rate position, it’s FAR from enough to get us out of crisis mode for more than a few months or quarters. As I mentioned in a previous post, there have only been two real periods of deflation in the modern world, the 1930s and Japan over the past 20 years. The 1930s were “cured” with the outbreak of World War II as we shifted to a war time economy. In Japan, the government has tried almost everything with no meaningful results and no end in sight.

That’s why the Fed has thrown the textbooks out the window and show almost no concern about any inflation problem. We already have a successful modern day model from the Volcker Fed days to fight inflation. They have nothing to go on to fight deflation.

People have been outraged at the profits being reported by some of the financial companies. But in the Fed’s eyes, giving them free money to either loan out or buy low risk, higher return securities was the only way to help them repair their decimated capital bases over a period of time without injecting another trillion dollars directly into the banks. It’s no secret that the Federal Deposit Insurance Corp. is essentially broke and Bernanke & Co. couldn’t let any of the major banks force the FDIC to make emergency arrangement with U.S. Treasury. It’s bad enough now that the FDIC is going to force banks to pre-pay future fees; can you imagine the cost of bailing out Citibank and/or Bank of America?

Over the years, I’ve written my fair share of critical articles on the Fed, especially Alan Greenspan who I believe was a major contributor to the stock market crash of 1987. For all his supposed brilliance, from my seat, he left rates way too low for too long and choked off growth for too long on the opposite side. In less than 15 years, the Greenspan Fed presided over the crash in 1987, Long Term Capital debacle in 1998 and the bubble/bust in 2000.

Anyway, not to let you think I can only be critical, I think Sheila Bair, chair of the FDIC, has done an absolutely outstanding job and continues to offer creative, non partisan solutions to some of our financial woes. And since January 2008, I give Ben Bernanke et al very high marks for their handling of one of the worst financial crisis’ in history. I don’t agree with everything they’ve done, but it’s not like there’s a roadmap to follow. Prior to January 2008, I often referred to Bernanke as Rip Van Bernanke, as I was convinced the man was asleep at the switch during the very early stages of the crisis when sub prime was the main issue. I still remember his 2007 commentary about sub prime being contained and no recession was on the horizon.

Getting back to the current Fed’s behavior, it’s unlikely that rates are going up any time soon, but remember that the Fed only controls very short-term rates and affects products like your home equity line. Longer-term rates are a function of supply and demand along with inflation and are determined by the “free” market. In normal times, mortgage rates are a function of the 10 year treasury note, however, the Fed has been buying all kinds of mortgages during their quantitative easing process to put more money into the financial system.

While I would love to have been a fly on the wall during all those scheduled and emergency Fed meetings from 2007 through today, I certainly don’t envy the position they are in. They have been forced to pick their poison in what is almost guaranteed to be a very rough and rocky road for the foreseeable future. But it almost feels like this is why he was put on earth, for his lifelong academic study of the Great Depression to be put to use. I often wonder if Ben Bernanke would have taken the job had he known beforehand what he was awaiting him.

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