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Watch out! Is the Fed pushing us into another bubble?
Started:April 23rd, 2012 (06:29 PM) by kbit Views / Replies:573 / 0
Last Reply:April 23rd, 2012 (06:29 PM) Attachments:0

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Watch out! Is the Fed pushing us into another bubble?

Old April 23rd, 2012, 06:29 PM   #1 (permalink)
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Watch out! Is the Fed pushing us into another bubble?

FORTUNE -- In a recent series of college lectures, Ben Bernanke sounded a positive note, extolling the Fed's low-interest-rate policy and predicting sustainable economic growth.

I want to believe him, but his words echo the confidence exuded by the Fed in late 2006 when it missed the housing bubble. Is it missing the bond bubble now?

The Fed has maintained interest rates at or near zero for four years running, even though the financial system has been relatively stable since 2009. The Fed's actions have kept Treasury bond prices high (while keeping the government's interest costs low), but the fundamentals do not support the high valuations, given the fiscal mess we are in. Sooner or later, the bond bubble will burst.

History has shown that a structurally weak economy combined with a fiscally irresponsible government propped up by accommodative central-bank lending always ends badly. Absent a change in policies, a toxic brew of volatile interest rates and uncontrollable inflation could define our future.

As we saw in the years leading up to the subprime crisis, yield-hungry investors are taking on more and more risk. Pension managers are investing in hedge funds, and gullible investors are buying up junk bonds.

Meanwhile, low-yielding assets pile up on the balance sheets of more risk-averse banks. If interest rates suddenly spike, bankers may find that the paltry returns on their loans are insufficient to cover interest on their deposits.

(Does anybody remember the S&L crisis?) Most important, retirees and others who want to keep their savings in supersafe liquid investments are earning returns of 1% to 2% (if they are lucky), while inflation creeps higher, now hovering around 3%.

And what are the benefits of ultralow rates? The stock market has experienced paper gains. Homeowners are refinancing their mortgages, giving them more to spend on goods and services (though much of that spending goes overseas to buy products, as our burgeoning trade deficit shows).

These benefits may help in the short term, but they do not address the long-term problem with our economy: We consume too much and produce too little.

Some banks and investment funds benefit from low rates because they can take the cheap money and get higher yields with it overseas.

Unfortunately, loan growth in the U.S. is moribund. Community banks that rely on domestic lending -- particularly small-business lending -- tell me they would lend more if they could get a higher rate on loans. But who wants to lend into an uncertain fiscal and economic environment for a few hundred basis points?

The biggest beneficiaries of loose money, are our profligate elected officials who refuse to come to grips with budget deficits and an exemption-laden tax code. As long as Treasury can borrow cheaply to paper over the real problems, politicians can demagogue about overspending (GOP) or undertaxing (Democrats) while dodging their responsibility to work together to fix our problems.

Fed defenders argue that Japan has kept rates low even while running up huge debts. But Japan enjoys a trade surplus, and its debt is held domestically. In contrast we run persistent trade deficits, and foreigners hold over half our public debt. To the extent foreigners keep buying Treasuries, it is because Europe's problems are worse. In short, we are the best-looking horse in the glue factory.

The economy is finally starting to recover, albeit modestly.

The Fed should declare victory and not intervene if the market wants to push rates up a bit. Start deflating the bubble before it pops. This will help savers, and possibly make it easier for small businesses to get loans, while leaving plenty of room for mortgage refinancings.

Who knows? We might see increased demand for homes as new buyers come into the market to lock in the low rates. Most important, higher rates will send a wake-up call to Congress and the administration to do their jobs. Excise special-interest tax breaks, and get entitlement and defense spending under control. We need more leadership from our politicians and less easy money from the Fed.

Watch out! Is the Fed pushing us into another bubble? - The Term Sheet: Fortune's deals blog Term Sheet

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