Would The U.S. Economy Have Double Dipped If The Fed Raised Rates in 2003?
The Chris Whalen interview on CNBC has me thinking about the Federal Reserve’s policy dilemma right now. If you haven’t seen his comments on interest rates, read my post Roubini, Bremmer and Whalen: Fixing the Financial System and Double Dipping and watch the clip.
- In 2001, following a massive stock market and capital spending bubble, Federal Reserve Chairman Alan Greenspan worried that the U.S. faced a severe recession. He began cutting interest rates down to 1% and kept them at that level until 2004, raising them slowly only 0.25% at a time thereafter.
- With interest rates so low, the financial services industry sensed a lot of money could be made and went all in on real estate, seemingly unaware that low interest rates were masking large risks.
- Meanwhile, Americans had been anticipating a nasty downturn after the bubble burst. But, they soon realized that money lost in the stock market was more than offset by rising home prices. So, Americans continued to spend freely.
- As Americans spent freely, the U.S. went further into debt with the rest of the world. Foreigners, used their dollar IOUs from these debts to start their own bubbles too.
- Eventually, things started to unravel in 2006 when those that could least afford to purchase homes — so called subprime borrowers — started to default in the U.S., prices having run well out of their range of affordability.
We all know that the easy money led to the housing bubble, just as it had done in the 1990s with the technology bubble. Doesn’t it seem like we are on that very same path right now? Yes, I know the downturn is more severe, but on the whole, it is the same turn of events: severe shock and lingering unemployment met with low interest rates and fiscal stimulus.
Now go back to early last decade after the technology bubble popped. Stocks were amazingly weak and didn’t bottom until autumn 2002. Unemployment peaked in June 2003! That’s 19 months after the recession ended. We were in a world of hurt. People forget. I guarantee you Americans would not have spent so freely if rates were higher.
Here’s how David Leonhardt of the New York Times covered the story in June 2003 when unemployment was peaking:
Trying to bring the long economic downturn to a halt at last, the Federal Reserve cut short-term interest rates by a quarter of a point today, taking them to their lowest level since 1958.
To the disappointment of the stock and bond markets, the Fed rejected a half-point cut and explained in a statement that the economy appeared to be improving but could still benefit from easier credit.
”Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing,” the Fed’s statement read. ”The economy, nonetheless, has yet to exhibit sustainable growth.”
In a sign of how radically the Fed has changed its focus over the last three years, officials also said that concerns about price declines, rather than inflation, were ”likely to predominate for the foreseeable future.” The statement, economists said, signaled that the Fed, while still viewing the risk of deflation as minor, planned to keep interest rates low for an extended period.
Alan Greenspan defends himself and the ultra-low rates by saying in effect we surely would have double dipped and deflation would have stepped in had he not gone for the easy money. Is Sir Alan right?
Yes or No?
I’ll leave it at that and let you comment. We’ll run this poll out a few days and see what people say.
Source: Federal Reserve Lowers Key Rate To 1%, Lowest Level Since 1958, David Leonhardt, NYTimes