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Raising interest rates to hold inflation in check

Jan Garrison
 

Another housing bubble?

 

April 22, 2022

Are we setting ourselves up for another housing bubble burst like 2008?

According to Danielle DiMartino Booth, the author of “Fed Up: An Insider’s Take on Why the Federal Reserve Is Bad for America,” we could be if inflation is not held in check by raising the current interest rates.

The Culver Academies parent was on campus April 15 to talk about the Fed with the AP Economics class. She worked at the Federal Reserve in Dallas for nine years, serving as an advisor to President Richard Fisher, including the time the housing bubble burst. In 2018, Booth founded Quill Intelligence, a research and analytics firm. She currently serves as the chief executive officer and chief strategist. She is also a frequent contributor to other financial media outlets.

“One of the things I would do is take the Federal Funds Rate to 2.5% and have that be a permanent floor,” she told the class that included her son, William ’22. The current rate is at 0.33%. The Federal Funds Rate is the rate for banks to borrow funds from each other. After the financial crisis of 2008-2009, the Federal Reserve Bank’s Open Market Committee put quantitative easing into effect, which allows the rate to drop near zero.

Booth said she would never let the rate drop that low again “because of the damage that it has done over the years, which is why we find ourselves where we are today – on the brink of another global financial crisis.”

She explained to students that “trillions of dollars have been raised by private equity firms in a zero-rate environment.” Around 33% of all U.S. home transactions today – new and existing – are being paid for by investors “playing with somebody else’s money. That’s speculation unhinged,” she added.

The Federal Reserve Bank recently raised interest rates a quarter of a percent to try and slow inflation and another meeting is coming on May 3, Booth said. While Booth was working for Fisher, she advised against going to zero percent – which was established by the “Bernanke Doctrine.”

She told the students that a 2.5% Federal Funds Rate should to keep inflation in check. That number used to be 4%, she added, but it has been revised downward. When Paul Voelker was head of the Federal Reserve, he took the Federal Funds Rate up to 22% in 1981, grinding the economy to a halt, in order to tame double-digit inflation. His actions stifled the economy so bad that it was one of the worst periods since the Great Depression, Booth said.

“But that’s what Paul Voelker had to do,” she explained, “and by the time 1981 rolled around your price-to-earnings ratio (P/E ratio) – how you value the S&P 500 – was down in single-digit territory. It was at 8.5. It’s never returned to single-digit territory.”

That is because there was a “mutiny” against Voelker’s tight monetary policy in 1987, she said. “The country was ready to move on from it and, yet, Paul Voelker stood his ground and ended up getting ousted and replaced by Alan Greenspan.”

Two months after Greenspan took over the Fed, Black Monday (Oct. 19, 1987) happened. The Dow Jones Industrial Average dropped 23.4%. “People’s lives were ruined,” Booth said. “Wealth was destroyed on a level that we’ve never seen in U.S. history.”

 

Booth with the AP Economics class after her talk.

 

That is when Greenspan said the Fed, “in its capacity as the nation’s arbiter, stabilizer of the financial system, will backstop the banking and financial system. But that statement will live on in infamy because that was the day that the Fed Put was born.”

The crash was short-lived because of that, which saw the major banks open their lines of credit. But every time a financial crisis occurred since, the Fed came in with liquidity. The Tequila Crisis, which saw the collapse of the Mexican peso against the dollar in 1994 and the near-collapse of Long-Term Capital Management, a massive hedge fund, were two instances where the Fed stepped in, she said. With the latter, Greenspan asked the nation’s largest banks to contribute to keep the hedge fund afloat. All the banks did but two – Lehman Brothers and Bear Sterns.

“Memories die hard on Wall Street. I promise, memories die hard,” Booth said. But Long-Term Capital Management was salvaged, preventing systemic risk. That is the risk “that the Fed absolutely cannot allow.” But it created more speculation “that was so massive that we ended up with this Dot Com bubble of 2000."

The NASDAQ decreased by 80% and before it is over, the Fed came in with an even bigger infusion “and we end up with the housing bubble of 2002 to 2006,” which is the time Booth is covering the Fed as a reporter/columnist. “I was saying at the time the subprime equation is so massive that it could be global and systemic in nature. Banks were involved. Credit ranting agencies were involved. The United States government was involved.”

Booth said her opinions were not very popular at the time. But after writing a newspaper article about it, she received a phone call from Warren Buffett. After they talked, he flew her to Omaha for a meeting. “That was one of the highlights for my retirement,” she said.

Shortly after that, Fisher calls her to work with him at the Fed in Dallas. “That was when the housing bubble was kind of inflating and getting ready to burst.”

When it happened, it was felt around the world. Landesbank in Germany was heavy into subprime mortgages and was eventually taken over. Bear Stearns was also heavy in subprime mortgages. But instead of a bailout, it was purchased for “pennies on the dollar” by JPMorgan Chase, she said. And Lehman Brothers was simply allowed to fail. She reminded the students who didn’t write the checks back in 1998.

Banks around the world were collapsing, she said, but American Insurance Group (AIG) was rescued for $85 billion. Bank of America bought Merrill Lynch and Countrywide Financial, which was “the biggest subprime lender.” Morgan Stanley and Goldman Sachs were given banking charters so they could be rescued. “Everybody was rescued,” she said.

And it was during this time, in August 2007, the Bernanke Doctrine was adopted, which increased the strength of the Fed by allowing it to take the Federal Funds Rate down to zero. “Totally self-serving,” Booth said. “For the Fed only and at the expense of lending commercial banks across the country.”

“Speculation becomes unhinged because you’re in a zero-interest rate environment,” Booth said. “When money is free, you can play with it.

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