Five years ago on the eve of another of the Fed’s annual financial symposiums at Jackson Hole, we wrote the following:
"Since 1999 when the financial bubble was in full bloom (due in large part to the Fed) we have been saying that the central bank faced a dilemma with limited choices—-none of them good. They could either kill the bubble, let the economy and markets take a hit and come out of it ready to resume healthy growth—-or they could keep extending the bubble for a while longer with far worse consequences down the road. The Fed, under Greenspan, chose the latter course, resulting in a dangerous housing bubble following the financial bubble of the late 1990s. This is evident in the fragile economic unbalanced recovery, the massive trade deficit, low consumer savings rate and record household debt. The standard measures of the economy indicate to many that Greenspan has won his bet, and the Jackson Hole symposium will probably be full of praise for his long tenure. We hope that they are right, but we believe that the final word on Greenspan’s reign as Fed Chairman is not yet written, and history may not view him kindly."
Now, five years later another Jackson Hole symposium will attempt to find solutions to the economic mess that partially resulted from the Fed’s reckless actions. The problem is that an already sub-par recovery (if we can even call it that) is giving signs of petering out even after all the massive stimulus programs provided by the Fed, the Administration and Congress. Sales of existing and new homes have dropped to new lows while consumers beset by high unemployment, minimal wage increases, near-record debt and limited access to credit are reluctant to spend. At the same time the inventory replenishment that was one of the few contributors to growth is now winding down and yesterday’s report indicated that core capital goods orders decline by 8% in July.
With the recognition that economic growth is showing signs of coming to a halt, the talk has turned to the possibility of more quantitative easing or QE2. The problem, though, is that after TARP, the stimulus plan, Fed purchases of $1.7 trillion of government securities and near-zero interest rates, there is little more the Fed can do that they haven’t already done. At this point the Fed cannot use monetary policy to force companies, banks and consumers to take credit that they do not want to use. In economic literature, this situation is known as a "liquidity trap, a phrase you will probably hear a lot in coming months.
The dilemma is well presented in today’s Wall Street Journal op-ed column by Alan Blinder, a Princeton economist and former Fed member, who is certainly not a perma-bear. The article, called "The Fed Is Running Low on Ammo", outlines three options for the Fed—–expanding the Fed’s balance further, changing the "extended period" language in the Fed’s statement or lowering the interest rate on bank reserves. He then demonstrates that each one of these options has either negative political consequences, economic drawbacks or limited effectiveness. He concludes by saying that if the economy doesn’t pick up, it’s time to use even this "weak ammunition, although he obviously doesn’t think it would be of much help.
In sum we believe that all of the options with regard to economic policy are negative, a point being gradually recognized by the stock market. The S&P 500 peaked exactly three months ago on April 26th. Yesterday it found support at about 1040 for the third time, although it has temporarily dipped to 1010 on July 1st. In our view both of these support lines will be pierced and the market is likely to decline significantly from there."