Reader (and tennis buddy of my Dad) Jim Haynes writes:
I think the Fed has effectively abandoned its traditional aversion to inflation, and might even welcome a modest increase in its rate. This is why:
1. Although Alan Greenspan in his autobiography would have us believe that he didn’t make any important mistakes while Chairman of the Fed, in fact, however, he had an aversion to prophylactic measures. His tendency was to let bubbles develop, and then to deal with the consequences afterward. That was evidenced by the stock market bubble culminating in the stock market deflation beginning in 2000, followed by a commendable easing of credit to avert a worse disaster.
2. The Maestro continued to ease excessively and too long and thereby allowed a housing bubble to inflate to absurd proportions. Ben Bernanke is now saddled with the consequences.
3. This housing bubble, I believe, is potentially far more serious than most people acknowledge. They look at this bubble as it appears today. Yes, foreclosures are at record levels. Yes, financial institutions have lost well into twelve figures. But, most believe, the problem is now contained as a result of the Fed’s loosening and its expressed willingness to take further action to maintain credit availability. All of that may be true, for now. The problem, as I see it, is that we may be at an early stage in the reduction of house prices. I suspect for many home owners the real pinch has not yet been felt; they are far from the point of panic. Homeowners today are waiting for prices to recover. Six months or a year from now, they may expect continuing declines in house prices. I suspect the present stage in housing is like the early stage of a stock market decline during a period of gradual losses, unpleasant but acceptable. We have yet to come to the time of capitulation, of panic selling, a time, too, when potential buyers are more wary of the “falling knife.” A severe and prolonged housing bear market may await us. (The analogy, I admit, has its limits. Stock is easy to sell. Among other things, sell your home, and you must find another place to live.)
4. I suspect the Fed sees the situation somewhat along these fearful lines. Its pronouncements express due concern for greater inflation and a determination to prevent it. But I believe when Mr. Bernanke suddenly awakens at 2:00 AM, his panicked thoughts are not of inflation, nor of mere recession. I believe the terror he feels is the terror of a death spiral in housing prices, and a consequent depression, as the asset principally relied upon by most Americans suffers continuous erosion of market value. In the process, tens of millions of formerly free spenders could move from a feeling of complacent comfort to a chilling fear of real poverty lurking close by. They will be reluctant to buy a Big Mac, much less a new Buick. I suspect the feeling of terror to which he awakens at 2:00 AM does not wholly depart from Mr. Bernanke with his morning cup.
I think Jim’s right. I’ve been sort of hinting at this point, but probably haven’t made it clearly enough: The reason Bernanke’s acting the way he’s acting is because he thinks there’s a risk of a total economic wipeout. Not a certainty, but a very real risk. And he’s probably right about that.