Don’t get so worked up about the Fed

I personally prefer mass stupidity / myopic decision-making as an explanation. Unfortunately, that is somewhat difficult to incorporate into a model…

I don’t get it…

The Federal Funds Rate was dropped to 1% for a year or so, and was generally kept very low in other years. We know that newly-created money is going to be loaned out in one fashion or another, because the decision to lend is effectively a prisoner’s dilemma for bank. I can understand how low rates in the long-term could make this worse, but it seems like short-term low rates could also cause a problem. After all, the housing and dot-com booms were not long-term phenomenon, so I wonder how relevant long-term interest rates are.

But, were there somehow more wise investments to be made just because the the Fed decided to drastically lower interest rates? How would that be possible? And if there weren’t any more good investments, then how could the credit expansion possibly go into wise investments?

Alex, some people were certainly stupid. But most I know who were involved in either the housing or dot-com bubble were simply riding the boom, hoping to get in and get out before it burst. Thats certainly not a scientific observation, of course Still, if its truly mass stupidity, then what could be done about it? A democratic government can be no help in a true case of hysteria, for obvious reasons, though I suppose we don’t have a purely democratic government anyways. But I seriously doubt that most investors were actually unaware of the bubble, and the danger.

“So if you want to blame the subprime crisis on loose monetary policy from the years of the dot.com bubble burst, you have some explaining to do.”

I don’t understand why Tyler brought the Fed into this discussion. The authors of the article don’t even mention the Fed as far as I could tell, though I read quickly. Their proposition is that the conventional view that the stock market moves in the opposite direction of long term interest rates is suspect, and they make a good point. The Fed has the greatest influence over short term rates, not long term rates. What determines long-term interest rates? Short-term rates, expected inflation, ROI on competing assets, supply/demand and other things.

I suspect that concern over inflation dominates because it has the greatest potential to cause harm to bond investors. During the 1990′s, inflation as reported by official indexes was low by historical standards. So long-term interest rates could remain low. Nevertheless, the money supply grew rapidly during the 1990′s. How did we achieve low inflation with a rapid growth in the money supply? Rapid productivity growth. Still, the extra money had to go somewhere and in the late 1990′s it went into the stock market, then into commodities and real estate. It now appears to be going back to the stock market.

The excess money supply goes into assets, generally, but not always into long-term bonds, which would affect interest rates. It seems to me that if Tyler really wants to test his theory that the Fed isn’t responsible for high asset prices, he needs to look beyond this paper. He would need an index of the major asset categories, stocks, bonds, real estate and commodities, and compare that index with the money supply, not long term interest rates.