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September 24, 2007

Fed Projects a Four Year Long Recession
by Michael Swanson

Aside from the dollar and long-term bonds all markets went up last week as the Fed demonstrated that it is more fearful of a slowing economy and banking woes than inflation. In fact, it is willing to sacrifice the dollar to save the banks. Just last month, the Fed was saying that the threat of inflation is just as great as the threat of a slowdown in the economy. Now it is cutting rates in a huge way as the DOW is near its all-time high, gold is making new highs, and the price of oil is exploding.

The Fed is obviously terrified. I have noted in the last podcast that Bernanke built his career on a doctoral thesis that claimed that the Fed didn't cut rates fast enough during the 1929 stock market crash. But if you look at a chart of the Depression bear market with an overlay chart of interest rates you'll see that the Fed cut interest rates as the market topped. A few years later when the market finally bottomed you'll see that they had been lowering rates all of the way down.

What Bernanke believes is that the Fed should have cut rates all at once during the start of the bear market instead of gradually over two years. He seems to be putting this belief to work right now. It means that he is gravely concerned about the state of real estate and banking in the United States.

As the NYT reports:

Those wanting to understand the Fed's reversal can profit from reading two papers by Fed officials which were released this summer as the credit squeeze was worsening.

Taken together they constitute an admission that the Fed was surprised by the housing and borrowing boom on the upside, and now it fears it will be surprised on the downside.

One paper, by Karen E. Dynan, a Fed economist, and Donald L. Kohn, the Fed's vice chairman, asked why a strong economy had left Americans deeper in debt than ever before.

"The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation," they concluded. In other words, Wall Street and rising home prices made it easier to borrow more money, and consumers did so.

That led to more consumption than would have been expected. Now, the authors say, "an unexpected leveling out or decline" in home values could have the opposite effect.

And, Frederic S. Mishkin, a Fed governor, said in the other paper that this leveling or decline could, in turn, have a bigger effect on the economy than the Fed anticipated.

"Although I generally do not place the housing and mortgage markets close to the epicenter of previous cases of financial instability," he wrote, "I would note that the current situation in the U.S. could prove to be different."

Mr. Mishkin said he had modified one Fed economic model, concluding that a 20 percent fall in home prices could cause consumer spending to fall by 2 percent within two years, about twice what the old model forecast.

But that was not the point Mr. Mishkin wanted to emphasize. Instead, his model showed that much of that damage could be averted if the Fed acted rapidly to cut rates -- as it is now doing.

When Alan Greenspan was at the Fed he often had Fed governors write papers to rationalize and justify changes in Federal Reserve policy. One should read the Mishkin paper mentioned above to understand what the Fed is doing now. If the credit markets don't revitalize in the next few weeks you can expect to see the Fed lower rates again by another 50 points at their October FOMC meeting no matter where the Dollar, Gold, or the DOW are. They have signaled that they don't give a damn about the Dollar. All they care about is Wall Street.

One could look at this another way though. One could say that they don't care about inflation because they see a total bust in housing that will create deflationary pressures in the economy. Mishkin's paper projects negative GDP growth for the next five years, a Federal Funds rate falling two full points lower, consumer spending shrinking for five years, and the CPI going down and staying negative if housing prices decline by 20%. These negative trends are expected to begin now and accelerate for two and a half years.

He sees such a housing price decline as very likely as house prices fell by 16% from late 1979 through late 1982. Contrary to people who believe that real estate is the best investment you can buy because it never drops, it has dropped in the past. And with bubbles leading to busts it is happening right now. The question remains, when will it stop? When the Nasdaq topped in March of 2000 it didn't bottom for two full years. Real estate topped out a year ago.

Mishkin isn't just a normal Fed governor. He is one of Ben Bernanke's closest friends. The two served at Columbia university together and in 1997 they wrote a book together calling on central banks to make public targets for inflation. Mishkin's views dovetail with Bernanke's.

According to Mark Zandi, co-founder of Moody's Economy.com, housing prices will decline by at least 11% in the next 3 1/2 years. Zandi sees prices in New York city falling from between 1 percent and 7 percent for each of the next five quarters so there is a lot of leeway in his projections. Hey, if we only get an 11% decline and you cut the Fed model projections in half we're still facing a horrible recession.

Mishkin argues that "the task for a central bank confronting a bubble is not to stop it but rather to respond quickly after it has burst." Instead of lower ratings as economic conditions deteriorate as his models do, and show practically a depression coming as a result, he advocates cutting rates all at once just as Bernanke's doctoral thesis about the 1929 stock market crash argues.

What I have to wonder though is what happens if the Fed lowers rates by one percent or more in the next three months and real estate doesn't rebound? These theories have never been tried before by a Central bank. We don't know if cutting rates all at once will prevent the damage caused by a bursting bubble. It has never been tested. Even when the tech bubble burst in 2000, Alan Greenspan didn't lower rates until almost a year later and after the Nasdaq fell to almost half its value.

The problem is real estate is still overvalued just as tech stocks became overvalued in 2000. One would think that real estate will have to drop and return to a normal valuation before it can bottom out, so simply lowering interest rates may not have the wonderful effects that Mishkin and Bernanke hope they will.

What I do know for sure, which is all you need to know to make money, is that they are setting up an inflationary trend. As the Fed prints more money it has to go somewhere. Of course this is bullish for gold and commodities which are now leading the stock market. But it is possible that the DOW and broad market could also continue to go up too.

This article continues in the WSW Power investor section with a list of stocks to watch for buys. To access click here.

Michael Swanson,
WallStreetWindow.com

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