How the Fed creates bubbles and crashes

Are the lunatics running the asylum?  A news report released last month would seem to suggest so.

Consider the shocking revelation that the Federal Reserve officials were oblivious to the financial crisis brewing in 2007 until they found themselves in the middle of it.  According to 1,300+ pages of transcripts released in January, the Fed was consistently behind the curve in the months leading up to the start of the Great Recession in December 2007. 

At the beginning of 2007, many Fed officials, including Chairman Ben Bernanke, thought one of the biggest risks was that the economy might grow stronger than expected rather than weaker.  At the time, the Fed's key interest rate was at 5.25%, and amazingly, the central bank was leaning toward further tightening.

“My recommendation also is to take no action and to maintain a bias toward further tightening,” Bernanke said at the first meeting of the year.  “The housing market has looked a bit more solid, and the worst outcomes have been made less likely,” he said.  Bernanke obviously failed to foresee the subprime mortgages crisis and the fact that it would ignite the deepest financial crisis since the Great Depression.

It wasn’t until September 2007, after months of the brewing credit storm, that the Fed finally decided to take action and reverse its insane policy of monetary tightening.  But even then, the Fed’s actions in lower interest rates were tepid at best and were a case of too little, too late.  The Fed didn’t become serious about extinguishing the flames of the credit crisis until well into 2008, by which time most of the damage was already done.

Writing in the latest issue of Barron’s, Milton Ezrati chronicles the Fed’s long-term history of employing the wrong monetary policy in response to the economic cycle.  “The Fed should simply guide money-creation according to the economy’s fundamental needs,” he concludes, “draining liquidity when foreign flows create an excess and injecting it when events create a shortfall.”  Unfortunately, history leaves us little reason for assuming the Fed will ever embrace Ezrati’s sensible recommendation.

Ezrati noted that between the 1990s and today, the Fed’s erroneous monetary policy created no less than three major bubbles which in turn created major economic instability.  History leaves no doubt that the ongoing monetary stimulus response of the Fed to the latest crisis will eventually create even more instability down the road.  I’m betting that 2014 will be the year those chickens come home to roost.