Does the Fed chairman need a publicist?
I can't help but think that, considering I've read one disparaging piece after another regarding the Fed's decision to slash its target rate by 75 basis points last week. Not least among the critics are some of my colleagues here at the Fool. Charges have ranged from "The Fed is scared" and "Ben Bernanke made the cuts in a panic" to the idea that the notorious Jim Cramer is "pulling his strings."
What gives? Do we really have a knucklehead leading the Fed?
In Wall Street's pocket
The biggest knock on Bernanke seems to be that he cut interest rates simply to please Wall Street, while not considering the long-term effects that his policy decision would have on the dollar, inflation, or the economy as a whole. After all, if Microsoft (Nasdaq: MSFT) and Johnson & Johnson (NYSE: JNJ) could post strong earnings, certainly the economy isn't doing that badly.
Those critics feel that the Fed has fallen into the realm of moral hazard -- in other words, it's providing a safety net for those who made the greediest, riskiest, and downright stupidest moves over the past couple of years. By doing this, it's assumed the Fed is encouraging this behavior and sowing the seeds for the next bubble.
The real hazard
While I hardly disagree with the danger of moral hazard, I can't help but wonder what these critics believe is the optimal outcome in our situation. After all, as of Jan. 18 (the Friday before the rate cut):
- Home prices were in decline, and there was significant deterioration in pretty much any measure used on the housing industry.
- About 220 major U.S. lending operations had either gone bankrupt, ceased operations indefinitely, or sold themselves at a fire-sale price. Among them was Countrywide (NYSE: CFC), the largest U.S. mortgage lender, which agreed to be acquired by Bank of America (NYSE: BAC) for nearly 90% less than its 52-week highs.
- The stocks of most homebuilders had fallen through the floor, a number of (mostly private) homebuilders had already filed for bankruptcy, and there were more still right on the brink.
- On an equal-weighted basis, the S&P 500 had lost 16% since July 2007, with some sectors down significantly more. Among them, consumer discretionary and financials were each down 29%, tech was down 19%, and telecom was off 28%.
- Wall Street had already announced, and begun, thousands of layoffs. Except at Goldman Sachs, the employees remaining on Wall Street are not having a happy bonus season.
- Among the Wall Street majors,Merrill Lynch (NYSE: MER), Citigroup (NYSE: C), and Bear Stearns (NYSE: BSC) have all dumped their CEOs over the past year for abysmal performance.
- To maintain adequate liquidity, major Wall Street firms were forced to sell significant amounts of new equity at valuations far below those of the prior year.
- The continued existence of major bond ratings agencies has been called into question.
In short, while moral hazard considerations may still exist, the desire to punish mortgage, housing, and Wall Street evildoers has to be weighed against the lasting damage that this could inflict on the economy if we allow it to spread unchecked.
Stomping the housing market
But what of the inflated housing market? Some contend that the Fed's aggressive interest rate cuts after the dot-com bubble burst in the early 2000s let the housing market get out of control in the first place. They think that cutting rates now would only allow the bubble to stay inflated.
There is actually a lot of uncertainty surrounding much of the housing bubble, though, and in particular the connection between the bubble and interest rates. In a recent paper, economist Robert Shiller -- who has been very vocal in pointing out the danger of the bubble -- addresses the issue of housing prices and interest rates:
The fact that the [U.S. housing] boom has become so pervasive leads one to wonder if it is indeed tied up with the trend in interest rates. However, the uptrend in home prices clearly does not begin until the late 1990s, after most of the downtrend in nominal interest rates had passed. It seems that, although it might seem at first that there is a substantial negative correlation historically between asset prices and interest rates, this correlation is actually very weak.
Instead, Shiller argues that "important changes in the public's ways of thinking about the economy," along with speculative feedback and a social epidemic, fed the boom. What could be concluded is that the bubble needed a prick to break the public's real estate mania, but not the full systematic stomping from the Fed's interest-rate boot that some seem to crave.
For those still not convinced, it's also notable to consider that on a real basis, mortgage rates over the past few years have not been as insanely low as often assumed. With inflation lower and far less volatile than in decades past, nominal mortgage rates painted a far more accommodating picture than was actually the case.
Incentives, incentives, incentives
In the end, there are enough investors and commentators out there that there would have been an outcry no matter what the Fed did. The Fed's action upset the stock market and many of the economic bears who thought the situation should be allowed to unfold further. Had the Fed held off, well, there'd be a group shouting that it was being irresponsible and letting the economy crumble.
Personally, I find the assertions about Bernanke just a bit absurd. Despite his nickname, the Fed chief has been a strong proponent of using monetary policy to target inflation, and I find it doubtful that he has suddenly handed his decision-making powers over to Wall Street interests. Call me naive, but I trust that he's making very calculated moves to help steady the economy and help usher it back to healthy long-term growth.
So what am I doing in the meantime? I'm taking my time sifting through the heaps of stocks that have been trounced over the past year. They're not all bargains, but bargains are certainly out there. I'm no economics Ph.D., and I really can't say how or when this mess will clear up. What I do think, though, is that one way or another we'll come out the other side, and, when we do, I'll be glad to have snagged some well-run, quality companies while they were beaten down.
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