No shortage of bubbles and troubles

By Jim Jubak

The stock and bond markets rallied after the Federal Reserve held short-term interest rates steady at its Sept. 20 meeting. Investors believe that the Fed has successfully steered the economy between too hot and too cold, and we're headed for a just-right soft landing with inflation under control and the economy growing at a solid pace. The so-called "Goldilocks economy" will push both stock and bond prices higher.

But I think it's premature to slap the Fed on the back and say "mission accomplished." Truth is, the Federal Reserve still hasn't pricked the financial bubble that it created with nearly a decade of easy-money policies. Oh, the housing market bubble may be deflating, with or without the abrupt pop that ended the stock market bubble of 2000. But the Fed hasn't succeeded in sopping up the flood of cheap money it created when it drove short-term interest rates down to 1% in June 2003 and kept them at that level until June 2004. Now all that cheap money is pushing up borrowing in the commercial real-estate market fast enough to worry bank and savings-and-loan regulators. And that isn't the only sector in the midst of a bubble.

Washing away a curse

It might be better to name this the "Lady Macbeth economy." Cast Fed chairman Ben Bernanke as Shakespeare's bloody queen who cried, "Out, damned spot," as she vainly tried to wash the blood of a murdered king from her hands. In this economic version of the tragedy, however, Bernanke wanders the darkened halls of the Fed muttering, "Out, damned bubble," as he tries to wash away the financial curse left to him by his predecessor, Alan Greenspan.

The Fed made three points in its Sept. 20 post-meeting statement:

• "The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market."

• Moderating energy prices are likely to reduce inflation pressures over time.

• Some inflation risks remain and additional interest-rate increases may be necessary.

The bond market, however, seems to have heard only part of this message, the part about moderating growth and moderating inflationary pressures. Bond investors have been busy bidding up the price of 10-year Treasury notes ever since the last Fed meeting on June 29 in anticipation of exactly this mix of moderate growth and reduced inflationary pressures. That's why the yield on the 10-year note has sunk to 4.78% at the close on Sept. 20 from 5.22% on June 30. That 8% drop in yield in less than three months is a very strong vote in favor of the success of the Federal Reserve's policies. Bond buyers are willing to accept a lower rate of interest on these long-term notes because they believe that inflation and interest rates will be lower than they are now.

Harder to avoid raising rates

Of course, the bond market's belief in the Fed's conquest of inflation and in the likelihood of an interest-rate cut next year makes it harder for the Fed to avoid raising interest rates. Even with 17 increases in short-term interest rates since June 2004, the Fed has had great difficulty in pushing up long-term rates and interest rates on mortgages that are so often linked to those rates.

Rates on the standard 30-year fixed-rate mortgage didn't climb above 6% to stay until October 2005 -- 15 months and 11 rate hikes after the Fed began to increase short-term rates. And despite all those rate increases from the Fed, the interest rate on a 30-year mortgage had actually climbed only as high as 6.8% by July 2006, shortly after Bernanke and company raised short-term rates for what is, so far, the last time in this cycle.

Since then, with the bond market increasingly convinced that the Fed is done, interest rates on a 30-year mortgage have actually dropped. The national average for a 30-year fixed-rate mortgage was just 6.33% on Sept. 21, according to the data from Informa Research Services on the MSN Money site. That's an effective rollback in mortgage rates to March 2006, when the national average stood at 6.31%.

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