Preface: Once upon a time, Federal Reserve Chairman Ben Bernanke had very big shoes to fill. He arrived into the story of the American economy at the heels of Alan Greenspan, who holds the longest Fed Chair tenure in history. Immediately after becoming the Federal Chair, Bernanke was faced with major economic meltdowns, with prospects of a recession on the horizon.
Opening chapter: Though his public words regarding the economy were modest, stories began spreading about Bernanke’s true feelings expressed in private quarters. Within the confines of his private life, Bernanke had discussed his growing concern regarding the health of the economy – and he purportedly believed that the recession would be significantly worse than his public words.
Plot climax: On January 22, 2008, Bernanke made his first real move as Fed Chair, surprisingly slashing interest rates by an unprecedented three quarters of a percentage point during an intermeeting session. Bernanke’s actions certainly call for a page in the history books, as this was the largest rate cut since 1984. To Wall Street, this translated to an American economy facing an enormous financial crisis and pending recession.
How did the other characters in the economic story react to this historical event?
- The US Dollar fell significantly against most of the leading currencies.
- Homeowners lined up to refinance their loans.
- Gold rallied and closed up nearly $8 for the day.
- The Treasury yield spread between the 2 year and 10 year notes increased by 14 basis points.
- Within the first minute of opening on January 22, the Dow Jones Industrial Average plummeted 300 points, falling another 165 points – before finally rebounding to a 1% loss, down 128 points.
- The day after the announcement, the Dow experienced a 632 point daily swing.
- Japanese and European markets rallied, with the Nikkei 225 index gaining 3.4% and Britain's FTSE 100 closing up 2.9%.
Conclusion: Now the laughingstock of the financial market, Bernanke cannot be blamed for the economic meltdown we are experiencing. In fact, the economic mess he is left to clean up was created many years before him – by Greenspan.
Our current financial crisis was triggered by the failure of variable rate mortgages, which Greenspan enthusiastically advocated in his February 2004 speech. Greenspan now agrees that these disastrous variable rate mortgages were indeed prompted by the record-setting 1% benchmark interest rate announced in 2003. Greenspan and the Fed also took no actions, cursory or otherwise, against the flagrant wrongdoings in the financial markets, as these junk mortgages were transformed into bonds.
From a basic, macroeconomic perspective, cutting interest rates are meant to stimulate business investment – but outside of the textbooks, the sophistication of modern-day financial instruments and investor expectations cannot be enticed by simple rate cutting alone.
Rate cuts from the Fed are not enough to stave off the bear market, especially when major economic variables – such as housing, consumer spending, and the unemployment rate – are flagrantly in jeopardy. Also, considering that the mess in the economy took years to create, it will take Bernanke several years to fight off the bear.
With globalization erasing financial boundaries, investors can easily place their monies in other economies – which may be where you may want to invest in 2008 too – until Bernanke helps investors believe that American can indeed live happily ever after again.