The Fed played a part in igniting the conflagration it’s now trying to smother.
When the Federal Reserve slashed its discount rate by a half-percentage point earlier this month, it was trying to add a little lubricant to a credit market that seemed on the verge of seizing up. But by giving weary investors a chance to catch their breath, the move also gave them an opportunity for finger pointing – at avaricious mortgage lenders, at naive borrowers, and at rating agencies.
One culprit, though, has not only avoided blame but has come across as the episode’s hero. And that culprit is the Federal Reserve itself. Like some renegade fireman, though unwittingly, the Fed played a part in igniting the conflagration it’s now trying to smother.
Because the disaster was kindled years ago, responsibility for it belongs not to the current Fed board but to Alan Greenspan and his team of monetary policymakers. The fundamental problem, however, transcends the actions of any Fed chairman. Indeed, the Fed as it’s presently managed can hardly help causing sometimes ruinous market distortions.
Why did mortgage lenders earlier this decade start showering credit as if it were spewing from a public fountain? The answer is that credit was spewing from a public fountain – and that fountain was the Fed. In December 2000, the Fed began an unprecedented year-long series of rate cuts, reducing the federal funds rate from over 6 percent to just 1-3/4 percent – a level last seen in the 1950s. By mid-2003, two further cuts had reduced the rate to just 1 percent.
The general aim of these cuts was to keep a mild growth slowdown from getting worse. But they had the quite unintended effect of generating euphoria in the mortgage market by flooding it with funds. Lenders dramatically lowered mortgage rates and kissed old-fashioned lending standards goodbye. Buying property was never easier. As one jubilant industry insider put it, “Who could ask for anything more?” Continue reading . . .
