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Will the Fed's Zero Rate Policy Bring Another Speculative Bubble?

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At the recent Federal Open Market Committee meeting, Federal Reserve Board Chairman Ben Bernanke signalled that he plans to keep interest rates effectively at zero for as long as possible, and that he's ready to stand by with more quantitative easing (i.e. printing money) if necessary. But if the Fed's blaming the last recession on the financial meltdown from the subprime mortgage market, why is it so committed to recreating those same credit conditions that spawned Wall Street's worst-ever post-Depression crash?

There is no shortage of people to blame for the subprime mortgage fiasco: wayward rating agencies that ranked the risk of mortgage default as comparable to the risk of a US Treasury default; unscrupulous lenders who eagerly approved mortgages and then quickly resold them to financial institutions; over-leveraged banks that used depositors' money to play Russian roulette in the financial derivatives market; and asleep-at-the-wheel regulators (like the Securities Exchange Commission), who were either blind or indifferent to Wall Street's systemic risk to the subprime mortgage market. However, the real culprits behind the subprime mortgage crisis were the incredibly low interest rates that sustained the bubble. All the greed in the world could not have done what the Fed's easy-money policy made so simple.

Was it not the desperate search for yield that threw many an otherwise cautious pension fund into the arms of seemingly safe CDOs (collateralized debt obligations)? Beneath the AAA-rated vanilla wrapping paper were pools of subprime mortgages just waiting to go bust. The measly extra basis points they offered over government-funded AAA bonds may not seem like much when Treasury yields are 5 to 6 per cent, but they meant a lot more to return-starved pension plans when government bond yields fell to near-record lows.

Similarly, was it not the ridiculously low cost of credit that allowed banks to become so leveraged -- hence exposed -- to the subprime mortgage market? And of course, it was the same low cost of capital that allowed interest-free mortgages (negative amortization types) to be given out to anyone who would take them in the first place.

Neither the demand for financial products like CDOs that were funded by subprime mortgages, nor the supply of subprime mortgages themselves would have been possible in a world of normal interest rates. When the federal funds rate rose to 5 percent, an historically average setting, the subprime mortgage market collapsed, creating an insolvency crisis for financial institutions whose vaults were filled with reeking CDOs.

Of course it won't be subprime mortgages and CDOs next time, but if the Fed keeps rates at zero for long enough, you can count on financial markets' insatiable desire for yield to invent something just as toxic.