Tags: barry | elias | fed | bernanke | us | economy

Fed Logic Just as Stable as a House of Cards

By    |   Friday, 18 Feb 2011 08:45 AM

Testifying before the House Budget Committee recently, Federal Reserve Bank Chairman Ben Bernanke stated, “with output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the unemployment rate has returned to a more normal level.”

According to the Federal Reserve Board, total employment is 6 percent lower than the pre-recession level more than three years ago.

Historically, by this time employment is typically greater than it was at the onset of the recession. Keep in mind, the population and labor force have been increasing during this period, thereby exacerbating unemployment further.

According to Bloomberg News, Bernanke also suggested that real-estate prices are not “responding at all” to the Fed’s policy, and the (housing) bubble was “far greater than could be explained” by the central bank’s interest-rate actions.

With respect, I believe the chairman is seriously mistaken in his assessment.

The interest-rate policy of the Federal Reserve Bank was instrumental in creating and decimating the real-estate bubble. It enabled a steep increase in prices as well as the precipitous decline.

The Federal Reserve, directly and indirectly, controls two interest rates: the discount rate and the federal-funds rate. Private banks pay the discount rate to the Federal Reserve to borrow funds, and they pay the federal-funds rate to borrow from other private banks. The federal-funds rate is typically higher than the discount rate (usually one-half of 1 percentage point), since banks have less available funds to lend, and they represent a more risky environment.

From February 2000 to November 2002, the discount rate dropped from 5.25 percent to 0.75 percent, and the federal-funds rate fell from 5.75 percent to 1.25 percent: a very steep drop during a short period of time. This enabled a high degree of lending, which was not commensurate with the current income level.

In July 2003, something very unusual happened. The discount rate became two-tiered to reflect more-risky, less-liquid bank portfolios (one-half of 1 percent difference). More importantly, the discount rate increased while the federal-funds rate decreased, leaving the discount rate (2.00 percent / 2.50 percent) greater than the federal-funds rate (1.00 percent).

This essentially made it more expensive for banks to borrow less risky and more available funds from the Federal Reserve.

By July 2006, rates skyrocketed to 6.25 percent / 6.75 percent (discount rate) and 5.25 percent (federal-funds rate): an extremely sharp increase during a short period of time.

The large increase in rates during a short period of time placed tremendous upward pressure on a significant number of variable-rate mortgages. The higher rates translated into much higher monthly mortgage payments. This cash outflow couldn’t be serviced at the current level of income. Foreclosures increased rapidly. The available supply of real estate increased, which depressed price levels.

Further traumatizing the market were the depressed price levels of the financial derivatives that were leveraged against these real-estate assets.

Assets were sold to meet cash flow requirements. This increased the supply of real estate and its derivatives, decreased prices, reduced disposable income and aggregate demand, and sent economic activity into a downward, negative spiral.

By December 2008, the discount rate was 0.50 percent / 1.00 percent and the federal-funds rate was 0.00 percent - 0.25 percent, lower than it was in November 2002.

Contrary to Bernanke’s contention, the interest-rate policy implemented by the Federal Reserve resulted in an unprecedented financial collapse.

During this period, many senior level individuals in government and private enterprise claimed ignorance. At best, this claim suggests a high degree of incompetence.

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Elias
Testifying before the House Budget Committee recently, Federal Reserve Bank Chairman Ben Bernanke stated, with output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the...
barry,elias,fed,bernanke,us,economy
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2011-45-18
Friday, 18 Feb 2011 08:45 AM
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