Bernanke hits the joy button

By Julian Delasantellis

In the hospital with my fractured foot this month, I was introduced to the medical miracle called Patient Controlled Anesthesia (PCA). Basically, PCA describes a container of pain medication attached to the intravenous line, controlled by the patient himself through a thumb switch. The doctor would set an upper limit of analgesia I could self administer per given time period, after which, no matter how many times you pressed your joy button, nothing would come out. I do not believe that the creators of PCA should receive a nomination for the Nobel Prize in Medicine, for the Nobel Peace Prize seems much more appropriate.

And now we have US Federal Reserve chairman Ben Bernanke, whaling away at his joy button, rapidly approaching his upper limit.

For the sixth time since last August, and, more amazingly, for the second time in nine days, the US Federal Reserve has decreed another sharp cut in short-term interest rates, this time twin 50 point cuts of the Discount Rate, to 3.5%, and the Federal Funds Target Rate, to 3%. Less than one month into the new year, the Fed has already engineered a quantity of interest rate easings, 125 points, that only the most optimistic of Fed observers predicted for the whole year.

I remember that after the great equity market crash of 1987, a floor trader was asked about how long the selling could last. Well, he said, the market lost 22% of its value that day, so, at the maximum, this could only last a bit over three more days.

Just as stock prices can't move below zero, there is an implicit floor past which short-term interest rates can't be lowered, and the United States is currently falling towards that level like a piano thrown out of a skyscraper.

At the most basic level, interest rates are simply the price of money, the added remuneration a borrower must pay to someone else, the lender, to convince him that its worth his while to defer some consumption for the period of time which is the term of the loan.

As national macroeconomic managers have realized since at least the time of Hammurabi (and that was thousands of years ago), interest rate levels are key control tools for a national economy. Interest rates that are too high, like any high price, tend to depress and inhibit demand; in the case of investment, their high costs inhibit otherwise profitable investments that with lower rates would have been made.

Children at a toy store learn quickly about how unpleasant it is when things are priced too high, but, for an economy as a whole, it's just as bad or worse when things are priced too low.

Every once in a while, a radio station, say, Hot Oldies 97.5, will do a promo and have gasoline sold at 97.5 US cents for a few hours; the lines of cars around the block demonstrate the manner in which low prices stimulate demand.

In the case of money, its price, its interest rate, serves to interpret and implement a market economy's desires as to what projects will or will not receive investment. Too low interest rates, and investments get made that would not, and probably should not. As the manhunt for the perpetrators of the subprime crisis develops and intensifies, many are pointing fingers at former Federal Reserve chairman Alan Greenspan, for dropping and holding the Federal Funds Target Rate to 1% from mid-2003 to mid-2004.

By lowering the price of investment capital to near zero, this is said to have spurred the tremendous overinvestment in the US housing sector. The massive wave of condominium and single-family residence construction that followed defined the froth of the 2004-06 housing mania, and, as many of these projects now sit empty, boarded up and in foreclosure, their very presence signifies the waste of society's scarce capital that went to build them, not to mention the devastated fortunes and futures of those who owned or lent to them.

But what if the Fed lowers interest rates to the cellar, and still you don't get a spur in investment and economic growth? That has been the experience of Japan for coming on 15 years now. In September 1995, in response to the collapse of the "bubble economy", the massive overinvestment in Japanese stocks and real estate, (that sounds familiar, doesn't it?) the Bank of Japan lowered its discount rate to under 1%, where it has been ever since. (It sat at an unbelievably low 0.1% from late 2001 until last year.)

Still, the response, in terms of Japanese economic growth during this period, has been, at the most, lackluster. This has been due to capital flight and the fact that low interest rates may be a very ineffective policy implement in dealing with economic slowdowns arising out of crises from an over-leveraged financial sector.

That, too, sounds familiar, doesn't it?

One danger of rapid Federal Reserve easings down towards 1% that doesn't get as much attention as it should is the psychological effect.

An economy in crisis is like a building afire. If it's your building, nothing sounds more reassuring than the wails of the fire engines as they wind their way through the streets to you. Likewise, as the economic news grows ever-more grim (as illustrated by the shockingly low 0.6% growth rate, barely above that which signifies the onset of recession, for the US economy reported Wednesday on morning) business and investors will expect, and receive hope from, more help from the Fed in the future.

If the Fed continues to cut at a rate of 125 points a month, all possible help will be exhausted before spring; a little slower rate of easings does essentially the same by mid-summer.

It is a near certainty that there will still be more grim economic news (such as the bad news with the bond insurers that pricked the brief bubble of the stock market rally that followed on the Fed decision) hitting the markets by the time the simple mathematical fact that you can't cut interest rates beyond zero completes the Fed's actions.

Far from providing soothing and immediate relief, central bank interest rate moves act with a substantial delay, a time lag, as they work their way through the economy. This time lag can be at least six months to sometimes as much as two years. Thus, as the Fed commenced the current easing rate cycle during last August's financial crises, the economy was still feeling the contractionary effects of the interest rate hike cycle that finished in June, 2006. It will probably not be until early to mid-2009 that America will see any positive effects from this current wave of easings - assuming that the economy does not settle into a Japan-style contraction seemingly impervious to monetary management.

A common complaint regarding US monetary policy over the past two decades or so is that, with the wisdom of 20-20 hindsight, the last move of any interest rate change cycle is always a mistake.

Greenspan's Fed was cutting rates (to support the flagging re-election prospects of George H W Bush, perhaps?) almost right up to the election of 1992; later it would be discovered that the economy was in full recovery almost a year earlier. Greenspan was also still raising rates well into 2000, as the economy was starting to deflate from the popping of the dot-com stock bubble. More recently, Greenspan's last cut of 2003 stoked the housing bubble, which Bernanke's final hike of 2006 definitively killed off.

So, if Bernanke drives rates to 1% or lower, will it be seen by the beginning of the next decade as the chief contributing factor to the development of another ultimately destructive boom-bust cycle in the economy? With the current doleful experience with real estate and the subprimes still a very malodorous sensation in the nostrils of high finance, the next bubble will likely not be in housing; in this month Harper's, Eric Janszen suggests that loans to the renewable energy equipment and infrastructure sector might be the next financial crises that will be the inevitable result of a free market uber alles government ethic that regulates personal pet ownership more stringently than it does its financial markets.

Greenspan dealt with the time lag problem of monetary policy with the slow and steady approach; most of his rate moves were no greater than 25 basis points at a time. In that way, even if the Fed was doing what later would come to be seen as damage by cutting or raising one too many times, at least the damage might be contained.

Bernanke seems to have eschewed this approach; of his now six interest rate easings, four, the August 17 discount rate cut, the twin September 18 discount and Federal Funds rates cuts, and both of this month's cuts, have been 50 points or greater. This is the case even with many still potentially troubling indicators of future rising prices. These include a falling US dollar, and both high energy prices and sharply rising import prices presenting a very real argument that inflation continues to be a real threat to the US economy.

But like a young man who vows to be not like his father but soon finds out that the vicissitudes of adulthood have him making the exact same life choices as his progenitor, in one way Bernanke now finds himself walking in pere Greenspan's shoes.

As I explained in October (Reaping what is sown, Asia Times Online, October 6, 2007), in a review of Greenspan's autobiography The Age of Turbulence, Greenspan was always quick to cut short-term interest rates in times of crisis or panic in the financial markets; eventually, it came to be seen that his Fed was reacting to the markets, rather than the other way around.

With the current cut cycle commenced last autumn, Bernanke seemed to be going out of his way to impress on the markets his desire that his Federal Reserve would follow a new course, that it would not be led around by the markets. I explained last November (Bernanke: Don't take me for granted, boys, Asia Times Online, November 2, 2007, and Playing 'chicken' with the markets, Asia Times Online, November 17, 2007) I explained how he seemed to be indicating to the markets that, in the future, interest rate hikes, and especially cuts, would now be more closely aligned to changes in standard macroeconomic variables, such as the outlook for inflation or unemployment. Markets may rise or fall as may be, but it's not really a proper concern for a central bank.

Then came the stock market declines of November and the past few weeks. Suddenly, there Bernanke is, a chip off the old block, taking after his old da, cutting rates in reaction to market panic. The first line in the explanatory statement that followed the announcement of these cuts was: "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households."

But not only is the current Fed cutting in the face of the financial market's "considerable stress", they're turbo-cutting, cutting fast, frequently, substantially, even, as in both last August and last week, in between meetings.

In a little-noticed speech from January 11, Federal Reserve governor and believed Bernanke Fed board ally Frederic S Mishkin described the new, pedal to the metal Fed-cutting paradigm.

Policymakers should be prepared for decisive action in response to financial disruptions. In such circumstances, the most likely outcome - referred to as the modal forecast - for the economy may be fairly benign, but there may be a significant risk of more severe adverse outcomes. In such circumstances, the central bank may prefer to take out insurance by easing the stance of policy further than if the distribution of probable outcomes were perceived as fairly symmetric around the modal forecast.

In English, this ain't your father's Federal Reserve anymore. We're gonna cut and cut (as illustrated by new market predictions of further interest rate cuts for next month and beyond), and the monetary policy time lag be dammed; if we overshoot and a new boom-bust cycle develops, well ...

As in the old Chinese proverb and curse goes - may you live in interesting times.

Why does the Fed do it - why do they keep cutting rates on the markets' command instead of waiting for the time lag to cut in? As I wrote last summer as the cries for Fed easings began to mount, the current structure of the socio-political and socio-economic power nexuses of America reacts with absolute outrage to falling stock prices.

Poor children can snack on lead paint chips in schools redolent of overflowing sewerage, and through the night ambulances can crisscross the streets of America's great metropolises looking for emergency rooms that will accept a patient in cardiac arrest without health insurance, but if stocks go down, the panic buttons really get pushed, especially with a newsmedia so longing to report the stories that the critical upper-income demographic finds interesting and appealing.

But as the quick selloff that followed the latest rate easing proved, the path of least resistance in US, and most likely global, stocks still is down, and, at this rate, there soon will be little or nothing that the Bernanke Fed can do about it.

A common scenario of US television advertisements features an adult son turning to his father for advice; if Bernanke is soon forced to turn to Papa Greenspan for such wisdom, the scene should also probably include the mobs of rampaging upper-income stock investors, perhaps armed with pricey pitchforks freshly purchased from that oh so chic Restoration Hardware, all baying for his blood.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.