The Fed Is Culpable


Tomorrow’s Wall Street Journal will run a story ( on the release of the Federal Reserve’s minutes and the Fed’s continuing concern regarding the economy’s sluggish performance.

Today’s CNN-Money web site published an article ( on the possibility of recession in 2009, just in case we escape that misfortune this year.

These articles sharpen our concerns over the economy’s performance, but don’t resolve the question of whether or not we’ll tumble into recession. But perhaps that’s not so important. After all, Japan’s economy suffered a decade of poor performance, stagnation and slow growth. Whether or not that economy was technically in recession loses importance with historical perspective. We do know that a double asset-inflation – stocks and real estate – seized Japan in the late 1980s, and that the subsequent asset deflation precipitated the sluggish 1990s.

America’s recent experience is a little different. We suffered serial, rather than concurrent asset inflations. First came the bubble of the late 1990s, followed by the crash. Then came the real-estate bubble of 2002-2007, which is deflating now. The Fed was aware of both bubbles but chose not to deal with them, stating that price-inflation rather than asset-inflation was its primary concern. Yet, when the bubble burst in 2000, the Fed selected text-book easy-money policy to deal with that downturn.

But the Fed’s 2000 – 2003 expansionary policy had unintended consequences. Residential real-estate had been enjoying boom conditions in the late 1990s. Construction was strong and home prices were rising rapidly. That sector required no stimulation. The recession’s impact was confined to the business sector (corporate equities and capital expenditures) and did not spill into home sales and home building.

Consequently the low interest rates that the Fed perpetrated and perpetuated in 2000 – 2003 turned the peak of housing’s cyclical wave into an unanticipated tsunami. Construction, sales and prices rose and then rose some more. Critics called upon the Fed to restrain rampant asset-inflation by restricting excess ease in the credit markets. But the Fed chose to let the tsunami build and wash over everything, observing – as it had in the late 1990s – that price inflation was dormant.

Now that the tsunami has collapsed under its own weight, rather than the Fed’s policy initiative, there is little that the Fed can do to prevent the deflating tsunami from washing everything out to sea. Tight money didn’t pop the bubble, so easy money can’t repair it. We’ve had back-to-back asset inflations, and must now deal with the consequences of a follow-up asset deflation.

Observers have commented on the difficulty of breaking the asset deflation’s vicious circle. See today’s Wall Street Journal ( for an example:

“As home prices fall, more families see the values of their homes decline to less than the amount of money they have to pay back on their mortgages. That gives them an incentive to walk away from their mortgages and leave their homes empty, which puts more downward pressure on home prices, drawing more households into the loop.”

In an asset deflation, falling prices can boost supply and reduce demand, exacerbating rather than alleviating the underlying problem.

Too bad the Fed didn’t think of that when it was basking in the benefits of asset inflation. Now we must all live with a problem of the Fed’s creation.

© 2008 Michael B. Lehmann