Searching For The Truth: Will Greenspan's Punch Bowl Party End With Energy Hangover?

The Federal Reserve is given much credit for how it has seemingly minimized the post-bubble economic fallout from the NASDAQ crash four years ago. By lowering the Federal Funds Rate to a level that has been at or below the rate of inflation, the Fed spurred the US economy, largely by inducing appreciation in real estate prices throughout the US, which in turn led to increased consumer spending.

Did the Fed's monetary policies get us through the crisis, or did it simply delay the inevitable pain? Morgan Stanley's Steven Roach believes that the Fed though its monetary easing may have painted itself into a corner, and draws an analogy to the predicament in which the Bank of Japan has found itself:

By holding the real policy rate at or below the zero threshold for such a long period, the Fed has nurtured the development of the Asset Economy -- dominated by American consumers who have become dependent on the persistence of low real interest rates and the concomitant wealth effects generated by a steady stream of asset bubbles. With the equity bubble now having morphed into a property bubble, the Fed’s predicament becomes all the more intractable. That’s because the monetization of wealth created by property appreciation can only be extracted by debt. While that debt may seem affordable at low interest rates, it becomes exceedingly onerous at higher interest rates. With record levels of household sector indebtedness now pushing toward 90% of GDP, debt-service ratios already near historical highs, and ever-frothy housing markets drawing extraordinary support from rock-bottom interest rates, the perils of aggressive Fed tightening are plainly evident: Rate hikes could well mean game over for the income-constrained, saving-short, asset-dependent, overly indebted American consumer. If that’s correct, the Fed and the BOJ may both be in the same predicament -- unable to extricate themselves from bubble-induced low real interest rate quagmires.

Roach also questions the assumption of some economists that a predicted reversion to the mean in energy prices should provide stimulation to the economy similar to that of a tax cut, noting continued demand from China and little near-term relief in the supply situation. My own analysis of the future supply and demand of crude oil bears this out.

I would even go a step further and note that sustained long term energy prices have the potential to recreate 1970s-style stagflation, i.e. rising consumer prices and stagnant wages as energy costs are passed onto consumers and corporate profits are squeezed. As interest rates rise in such a scenario, the housing bubble that exists in many of the metropolitan areas of the US, particularly in California, could also be expected to burst. Disposable income would shrink and personal bankruptcies could soar as the interest rates on revolving consumer credit rise. A dampened economy would also pressure state and municipal budgets, leading to tax increases at a time when the economy could be very vulnerable. I suppose that the only bright spot in such a scanario would be that decreased consumer spending might ease the enormous trade deficit that the US has with the rest of the world. On the other hand, it might not be enough to offset the increased value of our energy imports.

The potential for economic meltdown has been present for some time, with the question always being what will trigger such a crisis and set it in motion. At this point, all the evidence points to energy prices as being that trigger.

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