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Is Greenspan inflating a new bubble?
Free money climate: Rock-bottom rates may encourage speculation
Jason Chow
Financial Post

http://www.nationalpost.com/financialpost/story.html?id=A9CE0BEB-9D23-4BB2-9843-766CA3C86C29

Tuesday, June 17, 2003

CREDIT: Dennis Cook, The Associated Press

Federal Reserve chairman Alan Greenspan, who has warned about the dangers of deflation, may be willing to cut interest rates further to keep inflation from disappearing altogether, BCA economists say.


GREENSPAN'S BUBBLES: Many strategists blame the Fed chairman for inflating the tech bubble with cheap money in the late '90s. Now some fear he is doing it all over again.: (Photo ran on pg. FP1.)

In a bid to ward off deflation, the U.S. Federal Reserve may have started inflating another bubble.

Some economists say the central bank, in its battle against falling inflation, has lowered interest rates so far that it has created a free money climate that could wreak havoc on the investment landscape, just as Western economies begin to show signs of healing from the burst of the tech bubble.

With interest rates in the bond market at a 42-year low and expected to go even go lower next week when the U.S. Federal Reserve meets, the incentive to borrow money is high, and that can have dangerous consequences when it finds its way into the market. Household debt has soared to record levels, loans for stock-buying reached record levels this year, and economists say the cheap money has increased the investors' urge to speculate.

"The Fed does not want new bubbles, but this may be an inevitable by-product of the current unprecedented monetary stimulus," concludes a team of sober investment strategists at the Montreal-based firm BCA Research.

So why would the Fed go ahead and cut rates? Because they have to in order to keep inflation from disappearing altogether, the BCA economists said.

"Fear of a bubble is not going to stop the Fed," said Matthew Pugsley, managing editor and U.S. equity specialist at BCA. "The Fed is going to keep the pedal to the floor until they get what they want and that's increased inflation."

Lower overnight rates have kept bond yields low. Most long-term lending, including mortgages, is fixed to the bond market. With both short-term and long-term borrowing costs at a low, consumers, investors and businesses are bound to take on more debt.

Mr. Pugsley said this could mean high stock prices, a continued run in the hot housing market, and even an increase in corporate mergers.

"The Fed wants people to take risk," he said.

Already, the statistics show the U.S. consumer is hooked on credit and the Canadian picture is similar. U.S. household debt increased at an annual rate of 10% during the first quarter this year. Household debt also reached a record high -- 111% of household income during the same period.

While low mortgage rates have incited a run in the real estate market as consumers take advantage of cheap borrowing costs, some pundits, including economist David Rosenberg at Merrill Lynch in New York, argue the housing sector is already in a bubble. He pointed out that mortgage debt to house value ratio has risen to an all-time high of 45%.

"One characteristic of a 'bubble' is excessive leverage," he said. "That definition seems applicable in this case."

Fed chairman Alan Greenspan has warned over the past months of the possibility of "corrosive deflation" where falling asset values and profits would erode wealth. Mr. Greenspan's deflation talk has been interpreted as a sign interest rates will be lowered at the conclusion of the Fed's two-day rate-setting meeting next week.

Already, the Fed has opened its money spigots over the past three years as it has used monetary policy to try to kickstart the moribund U.S. economy. From a high of 6.50% in early 2001, the Fed has cut interest rates to 1.25%, the lowest level since 1961.

Rates are forecast to go even lower. Yesterday, the Fed Funds futures market was pricing in a 100% chance of a 25 basis point rate cut and a 50% chance of a 50 basis point cut at next week's meeting. A 50-basis-point cut (half a percentage point) would bring the rate to 0.75%, which would be the lowest level in 45 years.

The last time the Fed aggressively cut interest rates was in 1998 after the collapse of the Long-Term Capital Management hedge fund and the Russian government's default on its bonds threatened global financial stability.

To avert a crisis, the Fed quickly cut interest rates to 4.75% from 5.50% over a two-month period, and rates did not return to the earlier levels until November, 1999. Fear of a Y2K financial meltdown was also cited as a reason to keep rates low.

With the money spigots open, the U.S. economy roared: GDP grew at 8.9% in the final quarter of 1999 while stock indexes jumped to record highs in early 2000 as investors poured money into stocks, especially those in technology companies.

Many economists have since blamed the Fed's three rate cuts in 1998 for the ensuing bubble in the tech market.

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