How the Federal Reserve Lost Its War

The Federal Reserve's primary role is to set monetary policy for the United States. Through its actions, it determines both the cost and the value of the dollar.

That's a pretty powerful position. It's so powerful that whenever the chairman of the Federal Reserve speaks, people listen, and the stock market itself often moves. Because the Fed chairman's mere words have such tremendous impact on the markets, those statements often carry more weight than actual monetary policy shifts.

From "irrational exuberance"...
No Fed chairman in recent history understood that soft power better than Alan Greenspan. He was a master of obfuscation, so nearly all Greenspan's speeches required nuanced interpretations to comprehend. While that added quite a bit of complexity to analysts' jobs, Greenspan did consistently send one clear message to the market: Price stability mattered.

Under Greenspan, the Federal Reserve viewed maintaining a stable dollar as key to its other mission, maintaining maximum employment. For instance, his famous warning of "irrational exuberance" came buried near the end of a speech where he mostly talked about the importance of a stable currency and fighting inflation.

... To "extraordinary stress"
Contrast Greenspan's message of the benefits of a stable currency with the pro-inflation statements from his successor Ben Bernanke. Bernanke's speech in 2002 on the dangers of deflation earned him the derogatory nickname "Helicopter" by illuminating his pro-inflation bias. His call for China to strengthen its currency in 2006 reinforced that pro-inflation perception.

In fact, pretty much since Bernanke's 2002 helicopter speech, inflation has been accelerating. While he was not chairman at the time, Bernanke was still a Fed governor, and thus a key influence on the country's monetary policy. Coincidentally, 2002 was the same year when the price of housing started appreciating rapidly in California, Florida, and the Northeast.

Nobody should blame Bernanke for the housing bubble's initial formation. With the power the Fed has over the value of the dollar and inflation, the signal sent from his speech, however, could be viewed as having encouraged the bubble to continue to grow. After all, the only world where those derivatives based on subprime mortgages made any sense is one where housing prices always increase.

When inflation is the expectation, it's easy to discount the risk of falling prices. Yet thanks to so many investment bankers ignoring that risk, it was magnified through excessive leverage to the point where Wall Street itself was taken out when housing collapsed.

The real problem
When the housing bubble burst, it wasn't because people suddenly decided they didn't want to buy houses anymore. Instead, the collapse started when subprime borrowers stopped paying the mortgages on houses they had already purchased. Banks clamped down on that type of lending when it became apparent that "no money down, interest only with a great teaser rate" meant that the bank took all the risk of default.

With that spigot of easy money cut off, housing started to retreat. After all, the same $1,500-per-month payment buys much less house when it has to amortize a fixed 6% loan than when it merely has to cover a 2% interest-only teaser.

As a result, Bernanke's quest to restore liquidity to the debt market through cheap capital was doomed before it ever began. No amount of string pushing can entice lenders to loan money that they fear won't be paid back.

Collateral damage
While Bernanke's often-professed justification for his actions, to avoid a recession, is a noble goal, the damage caused by his misguided attempts to help might be even worse. Since his first surprise rate cut in January, the Fed's crowding out of private capital has caused widespread wealth destruction, even among profitable companies outside the financial sector:

Helicopter Ben, meet Sun Tzu
The problem was never a lack of people willing to borrow money, which is what you address by lowering rates. Instead, the problem was (and is) that the people who have money to lend don't believe that current interest rates adequately compensate them for their risk of loss. This explains why all of Bernanke's attempts to stoke lending, including:

• Panicked rate cuts,
• Brokered acquisitions,
• Direct capital infusions,
• Bailouts, and
• Globally coordinated panicked rate cuts

have all failed miserably. Bernanke is fighting the wrong battle, and as such, has already lost the war.