The Federal Reserve is now well down the road in its great, unprecedented monetary experiment. By maintaining interest rates at or near zero, the Fed is attempting to induce investors to take risks by shifting cash that earns essentially nothing and investing that cash in stocks and bonds. To date, the Fed has spent trillions of dollars buying assets, mostly bonds, fueling a four-year rally in asset prices.
The Dow Jones Industrials are trading near all-time record levels. High-yield bond indices suggest that many bonds are trading at a significant premium to their par value. Now we know what prices look like when the Fed is a very large buyer of assets, and when the Fed is sponsoring cheap money through its zero-interest-rate policy.
But what will prices look like when the Fed shifts from being a buyer to being a seller? Public statements by Fed Chairman Ben Bernanke suggest that the Fed will make just the right moves, in just the right manner, at just the right time. But the Fed’s record as an economic forecaster is certainly less than stellar, and one does not have to study Fed history all the way back to 1913 to see frightful forecasting errors.
Just consider some of Chairman Bernanke’s public statements in the run-up to the 2008 meltdown:
October 20, 2005: “House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals.”
February 15, 2006: “Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”
May 17, 2007: “All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
January 10, 2008: “The Federal Reserve is not currently forecasting a recession.”
While the Fed’s zero-interest-rate policy is meant to encourage investors to shift cash into riskier assets, those same investors might do well to ponder this question: How much of one’s life savings should be risked at the encouragement of an institution whose recent record includes missing the call on what ultimately happened to the housing sector, and to the broader economy?
Coleman Andrews, who was a co-founder of Bain Capital, is CEO and chief investment officer of RMWC, a private investment firm.