The Federal Reserve under Ben Bernanke began aggressively lowering interest rates at the end of 2007 in response to the severe economic downturn caused by the collapse of house prices and the related difficulties falling house prices had on the banks and other institutions that made loans using houses as collateral. Many are concerned that these policies will ignite a period of hyperinflation in the United States.
Bernanke, prior to taking the position as the chairman of the Federal Reserve, was an academic who studied the Great Depression and wrote extensively on the failures of monetary policy by the Federal Reserve at the time. He also wrote about the crisis of deflation Japan faced when their combined stock market and real estate bubbles deflated throughout the 1990s.
Bernanke believed that quick and decisive action on the part of the Federal Reserve was necessary to prevent a destructive deflationary spiral as was witnessed in the United States during the Great Depression and in Japan during the 1990s.
By lowering interest rates and creating price inflation, Bernanke hoped to devalue the currency and provide market liquidity through both domestic and foreign investment. Once the real rate of interest was below the level of inflation, borrowing would be strongly encouraged as the value of the currency was falling faster than the interest rate being charged.
The increased borrowing would stimulate business growth and the general economy minimizing the deflationary impact of falling home prices. In theory, the lower interest rates would also serve to blunt the decline in housing prices as borrowers would again be able to finance large sums to support inflated prices.
At the time of this writing, the results of the policies of the Federal Reserve have not become history so the consequences cannot be fully evaluated. The primary foreseeable consequence of Federal Reserve policy is rampant price inflation. An economy that relies for 70% of its value on the spending of consumers will be strongly impacted by price inflation.
When a country knowingly devalues its currency, it causes a severe recession as the prices of imported goods and raw materials increases significantly. Perhaps a severe recession and price inflation is preferable to an economic depression like the one of the 1930s in America, but it is certainly not desirable.
Since stagflation of the 70's, the FED has shown a willingness to push the economy into recession before it allows inflation to get out of control. When the FED started lowering interest rates at the end of 2007, it appeared as if they may be moving down the path of hyperinflation; however, it seems unlikely they would take it to extreme.
One of the primary functions of the FED is to provide a stable financial system. Once the Federal Reserve begins to see economic growth and liquidity in the debt markets, interest rates may rise as quickly as they fell in order to stop hyperinflation from occurring.
There will be some benefits to a devalued currency. A less valuable currency is a boon to exporters. The United States has run a chronic trade deficit for many years, and much of the recent deficit has come from inexpensive goods imported from China. The trade imbalance may correct itself with currency devaluation. Of course, this rebalancing of trade will come at the cost of more expensive imported foreign goods and a commensurate decline in spending power from US consumers.
Also, prior to currency devaluation, wages in the United States were so high that jobs were being outsourced to foreign countries where people can be paid much less. Wages could not rise significantly from where they were without devaluing the dollar to prevent wage arbitrage from moving jobs overseas. The devalued currency provided some room for wage increases, and these wage increases could theoretically provide additional support for housing prices.
Currency devaluation and inflation eats away at the buying power of money. Although this may support house prices at marginally higher nominal price levels, real price levels, the price level adjusted for inflation, will remain unchanged.
Imagine if the Federal Reserve allowed inflation to cut the spending power of the dollar in half by 2011, and imagine if this level of inflation allowed house prices to remain stable at 2006 price levels for those 5 years. Many homeowners would feel relieved their homes did not decline in value, but this relief would be an illusion as the buying power of their money tied up in the value of their houses was cut in half.
Irrespective of the nominal decline in prices, the inflation adjusted prices will decline significantly going forward. In the Los Angeles market as measured by the S&P/Case-Shiller index, a decline in prices to levels of historic rates of appreciation as previously described will result in a 66% decline in inflation adjusted terms. On an inflation adjusted basis, buyers during the bubble will never get back to breakeven unless there is another real estate bubble similar to the great housing bubble.
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Date Published :
Jan 3 2009