Bernanke’s Quandry

House sinking in water , housing crisis,flooding, ect. conceptAt the end of 2006, housing prices in most areas of the United States were hitting their crest. As long as prices were rising, things chugged along very nicely. The beginning of the end was heralded when the Fed moved to raise interest rates. As rates increased, buyers began to decrease in numbers. As this demand waned, prices started to go down. This fall in prices caused the exposure of some abysmal lending standards in the subprime mortgage market.

As the rout continued, many borrowers started falling behind on payments, which forced a number of major mortgage lenders into bankruptcy protection. By May of 2007, UBS (Union Bank of Switzerland) shut down its Hedge Fund “Dillon Read Capital Management,” after a $100 million write-off. With a slowing housing market, rising interest rates, and high oil prices, the United States may be poised for the rebirth of an economic condition not seen since the 1970s: stagflation.

The Fed is faced with rising wages and prices coupled with stagnant economic growth (see our previous issue, The Ultimate 70s Retrograde, Qtr 1-2000). A former Federal Reserve Chairman, Paul Volcker, cured asset-inflation by raising interest rates so high that it threw the economy into a recession. Recent events suggest that the upsurge in inflation pressures could force the Federal Reserve to increase interest rates once again. In the past two years, the Fed had already started raising the Federal Funds interest rate from 1% to 5%. Federal Reserve Chairman Ben Bernanke had followed a path laid out by Alan Greenspan, who had been attempting a preemptive strike on inflation.

However, raising interest rates without reducing the overall supply of money has had little effect on the problem. Worse still, as the bulk of these subprime loans move into default, the Fed Chairman will have little choice but to add even more fuel to the fire by increasing the money supply. This, at precisely a time when money supply figures continue to form historic highs, is the last thing the economy needs.

In President Carter’s reign during the 1970s, Fed. Chairman Paul Volcker took the inflation fight to the heart of America with a 21% interest rate. Ben Bernanke, the current Fed Chairman, has apparently given up on fighting inflation; not only by taking the posture of perhaps lowering interest rates, but by direct open market purchases of Treasury Bonds (an act which has the effect of adding money into circulation). Homeowners during the last five years have used their homes as piggy banks by taking out home equity loans. As they struggle to pay down these lines their discretionary spending, a major engine of economic growth, will subside.

Next year, more than $1 trillion worth of the adjustable rate mortgages will reset based on Fed interest rates. As these credit instruments unfold, the Federal Reserve will have to consider the option of increasing the money supply at even greater rates, or else risk the complete collapse of the real-estate market. While they may not use direct intervention – they will provide the liquidity that will allow the banks and mortgage brokers to continue their activities.

Additionally, the legislatures may ease the pressure by providing bailout packages to various groups of homeowners throughout the country. Treating the bulk of the bad loans made to otherwise credit worthy consumers might mitigate the problem somewhat, and this may take some pressure off of the Fed. By providing liquidity wherever it is required, the temporary slowdown of the United States real estate market will be corrected. But all this liquidity must take its course; as the dollar’s weakness continues to accelerate in the coming months, look out for increased foreign investment in U.S. land.

Leave a comment

Your email address will not be published.