Former Fed Chair Benjamin S. Bernanke has just won the Nobel Prize. Mr. Bernanke left the Fed in 2014 and he is now a distinguished senior fellow at the Brookings Institution in Washington. He won the Nobel for his work on financial crises, including a 1983 paper that broke ground in explaining that bank failures propagate downturns and aren’t simply a side effect of them.
I am almost finished reading the book, " 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19," by Ben Bernanke.
This book describes, in great detail, every move made by the Federal Reserve from the 1970s to 2021. It was published on May 17, 2022 so it doesn’t cover the 2022 inflation or current Fed Chair Jerome Powell’s program to channel Paul Volcker to bring inflation back to the Fed’s target of 2%. Part of the book covers the Fed’s decision to target inflation at this level.
At the same time, I am reading “The Price of Time : The Real Story of Interest,” by Edward Chancellor. The author is a financial journalist who wrote a previous book about financial speculation.
“The Price of Time” is an excellent book which covers interest rates beginning with earliest human civilization. Lenders charged borrowers interest even before the invention of money. Ancient writing from 1700 BCE shows that lenders of barley seed at the start of a planting season charged the borrowers 33% interest to be paid after the harvest. (Apparently they knew from experience that this was a reasonable share of the increase from the harvest.)
The history of financial crises associated with low interest rates can be traced to the 1600s. Sequential bubbles and crises (including the famous Mississippi bubble of 1718 - 1720) coincided with unusually low interest rates which forced investors to speculate in risky schemes.
TINA (There Is No Alternative) to risky investments when safe investments (such as Treasuries and the equivalent) has happened over and over.
The main points of “The Price of Time”:
When safe interest rates are below the growth rate of an economy investors speculate in higher-yielding, riskier investments. This has led to spectacular bubbles which led to financial crises over the centuries. (See also “Manias, Panics and Crashes,” by Kindleberger.)
This is especially true when the real (inflation-adjusted) interest rate is lower than zero, when borrowers are being paid to borrow money.
After the 2001 dot-com bubble burst, Fed Chair Alan Greenspan held the fed funds rate too low for years. That gave rise to the housing bubble of the mid-2000s.
After the 2008 financial crisis, Fed Chair Bernanke held the real (inflation-adjusted) fed funds to less than zero in addition to Quantitative Easing to suppress longer-term interest rates. That gave rise to a stock market bubble which expanded radically after Jerome Powell’s monetary stimulus of 2020 - 2021. (I’m only halfway through this book so I don’t know yet if Chancellor also puts his finger on fiscal stimulus.)
If low interest rates and monetary stimulus stay in the banks and don’t get into consumer hands there will be asset price inflation but not consumer price inflation. However, if stimulus gets into consumer hands faster than the rate of productivity growth there will be consumer price inflation.
Targeting a specific inflation rate (price stability) has led to too-low fed funds rate in the past. The Federal Reserve did this in the 1920s.
I am having cognitive dissonance from “The Price of Time” because the evidence over centuries is convincing. Quotes from earlier bubbles and crises (such as Daniel Defoe commenting on the Mississippi Bubble) could just as easily have been written today.
The evidence is that the Federal Reserve blew these bubbles and then their “courageous” actions to save the economy were applauded.
As investors, we need to carefully follow the actions of the Fed. Will Powell actually increase the fed funds rate to a historical level of 2% over the inflation rate? In that case, the fed funds rate may stabilize at 4% if inflation drops to 2%. Or will he follow Bernanke’s book that claims the “neutral” fed funds rate has been falling over the past few decades? In that case, the Fed’s 2022-2023 medicine will be temporary and the fed funds rate will fall again.
Investors who have learned to expect bubble stock price increases may have to temper their expectations. Any increase in stock prices above the increase in real GDP is blown by excess monetary stimulus. We all love it but it’s unstable.