2000. 2007. 2011.
Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?
Asset prices in the world's emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world's emerging economies have started to worry about what will happen if all the hot money flowing into their economies and markets suddenly starts flowing out.
"As long as the world exercises no restraint in issuing global currencies such as the dollar," Xia Bin, an adviser to the People's Bank of China, said, "then the occurrence of another crisis is inevitable."
I think some degree of worry -- less than full panic but more than polite concern -- is appropriate at this stage. And that worry should play a role in shaping your investment strategy as the decade advances. In today's column, I'm going to lay out the "Oops, the Fed's done it again" scenario. Later this week, on MSN Money and my website, I'll tell you what I think you can do about that danger.
Just talking about exuberance
In 2000, I'd say the sin was one of omission. The Fed sat on the sidelines, aware that a stock market bubble was building but doing nothing to head it off.Remember how then-Fed Chairman Alan Greenspan talked about "irrational exuberance"? Well, it was all just talk. The Fed, which had the power to try to moderate the bubble by tightening credit on Wall Street, believed that trying to manage bubbles was futile. All a central bank could do was watch from the sidelines and then help clean up the wreckage.
And quite a bit of wreckage there was and still is. The Nasdaq Composite Index ($COMPX) peaked at 5,048.62 on March 10, 2000, and bottomed at 1,114.11 on Oct. 9, 2002. That was a loss, top to bottom, of 77%.
Eight years after the October 2002 bottom, the Nasdaq composite is up handsomely -- 131% as of Nov. 5.
But 10 years after the bear market began in March 2000, the Nasdaq has barely recovered half its losses. From a high of 5,048.62, the market had clawed back to 2,578.98 at the close Nov. 5. That means the Nasdaq Composite Index is still down 49%.
Making a mess
I'd put the Federal Reserve's role in the financial and economic crises set off by the U.S. mortgage mess in a different class. The sin here was one of commission. The Fed played an active role in creating this global meltdown and in making it as bad as it was. (Or should that be "is"?)To clean up the wreckage from 2000, the Federal Reserve lowered short-term interest rates. At the Nasdaq Composite's height in March 2000, the Fed's benchmark rate was 5.73%. The central bank kept rates above 5% for an additional year -- the benchmark rate was at 5.47% on March 7, 2001 -- but then it began to cut, and fast. By March 6, 2002, short-term rates were at 1.74%, and by the end of 2002 they were just 1.23%. By July 2003 the Federal Reserve had cut them to 0.96%.
And there they stayed. For too long, the Fed now concedes. A year later, through most of June, short-term interest rates were just 1.11%. That marked the turn in the cycle. Finally, on June 30, the Federal Reserve began to raise interest rates, though very slowly. By the end of the year they were at 2.27%. By November 2005, they had finally reached 4% again. And by June 2006, short-term rates crossed the 5% barrier.
But by that time, the low interest rates that had been intended to help clean up the wreckage of the bear market of 2000-02 had set off their own bubble, in real estate and lending.
In the fourth quarter of 2002, when short-term interest rates were 1.23%, the real median price of a U.S. house was $197,219. (All these prices are corrected for inflation.) By the fourth quarter of 2005, the real median price was up to $262,634. That's a 33% increase in the median price of a house in just three years -- without inflation. That's extraordinary appreciation for an asset like a family home in the United States.
And cheap money made it possible. It was possible to buy and flip for a quick profit. Possible to refinance and take money out to buy more stuff. Possible to buy more house than you could afford. Possible to find a lender who would lend you more than the house was worth. Possible to find a lender who wouldn't ask questions about your income or credit record.
By 2006, this price appreciation had peaked. The median real price of a house that year ranged from $250,000 to $263,000. But by the second quarter of 2007, it had dropped below $250,000. And it kept on dropping. By the bottom, which nationally may have been the first quarter of 2010, the real median price of a house was down to $169,158.
That's a drop of 36% from the 2005 quarterly peak to what may be the bottom in 2010. (And because the house they live in is by far the most valuable asset most families own, and because home ownership rates in the United States are much higher than stock ownership rates, that 36% drop in housing prices was more devastating for most families than a 77% drop in stock prices.)
Continued: Trust the Fed again?
WHY IT WILL SOON BE TIME FOR QE III
ok 2001, your short, wiki answer:
