For example, Feldstein wrote,
"But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.
In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy."
Clearly, Feldstein believes, as do I, that Fed rate cuts just won't do that much for whatever currently ails the US economy. It's my guess that if you asked Feldstein directly whether the Fed's rate cuts will have done much more than stoke future inflation, he would say "no."
He continues in his editorial,
"The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.
But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.
The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment."
Here, Feldstein explains that the unwise over-expansion of housing, and, by implication, the funding of said over-expansion with opaque CDOs, have resulted in real losses of wealth that will likely affect consumer spending. Thus, growth will at least slow, even if not reverse us into a recession.
Summing up, Feldstein writes,
"There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.
The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble."
However, I'm not entirely convinced of his contentions in these passages. For example, how are examiners supposed to 'allow for the potential bursting of the house price bubble?'
In hindsight, that sounds fine. However, up until said bursting, you can bet the banks in question would be screaming bloody murder and exercising whatever political influence they had, via Congress, to affect the examiners who were, at that point, baselessly criticizing still-performing assets.
As to the SIVs existing, that's another matter. But, even there, ultimately the banks took them back onto their balance sheets because they were obligated to provide funding when external markets dried up.
Who can say which housing loans should have been called into question prior to the beginning of the period during which funding for housing-related structured finance instruments or subprime mortgages ceased to come forward?
Other than making the general comment that growth in mortgage markets remained too high for too long, it's another matter entirely to be the Federal agency which unilaterally reins in credit expansion for those particular loans. What if various minority groups had, in that event, pressured the Fed and banks in question to continue lending, or suffer charges of discriminatory lending practices?
Aside from those last passages, however, I find Feldstein's analysis of the situation very much in concert with my own. We face a demand-pull threat of inflation, not the cost-push sources of prior eras. Money has already been relatively easy when the Fed began to cut rates last year. It's unlikely those lower rates have really sparked much new business activity or lending, because the greatest bar to credit expansion has been counterparty risk, not rate levels.
All of which reinforces my belief that the Fed's prior, and even near term future rate cuts won't materially affect our economy, other than bake in higher inflation rates 18-24 months out.
If this is true, precisely what has the Fed rate cutting program delivered to us as a benefit?
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