The Fed is a non-market force which artificially influences interest rates. Non-market interest rates can cause mal-invesment. For example, by keeping interest rates artificially low, the Fed encouraged debt to be created to fuel the housing boom. The market would have set interest rates higher, discouraging the boom, encouraging baby boomers to save, and ensuring a more stable banking system.
In the case of the housing boom, massive credit growth caused asset prices to become overpriced relative to commodity prices and wages. Houses have become unaffordable to many. Asset prices simply cannot be justified relative to commodity prices and wages.
When asset prices become too inflated, the market kicks in. Asset prices turn down. The market wants to realign asset prices to commodity prices and wages.
But the Fed doesn’t want asset prices to come down because asset prices lead to bankruptcies, especially among banks which are highly leveraged. The Fed is trying to encourage more credit creation via even lower rates and other means of stimulus. But the market is saturated with credit, and banks have to cut back their lending.
The new money that the Fed is creating is not going back into housing, but rather into commodity prices (and eventually wages once inflation frustrations cause work stoppages and shortages). The market is trying to realign asset prices relative to commodity prices and wages.
The likely result is that housing prices will come down and then move sideways for many years. Commodity prices will continue to go up, and eventually wages will follow. The Fed will eventually be forced to fight inflation by raising interest rates, which will continue to dampen asset prices. Eventually, after years of commodity and wage inflation, equilibrium will be restored, but it will be a painful process.
Fake Ben Bernanke
FakeBen.com
FakeBen is a blog to monitor the Fed and its actions and encourage community participation. At FakeBen, we believe that the Fed policy of the last two decades has created a credit bubble as large as that created in the 1920s. This bubble will lead to either inflation, a recession, or both.
