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The Financial Crisis: 'What Has This Got to Do With Monetary Policy?'


A spike in inflation was the catalyst for the 2008 financial crisis, not real estate imploding or mortgage delinquencies. And now the Fed is about to make another policy error.

The five-year anniversary of the Lehman Brothers bankruptcy has elicited all sorts of recollection and reflection about what caused the financial crisis and whether it can happen again. The conventional wisdom sees the financial crisis as a product of twin bubbles in real estate and credit, which were financed on the highly leveraged balance sheets of the traditional and shadow banking system for which Lehman was the poster child.

Identifying the bubbles was not difficult. There were plenty of warning signs and many shrewd investors from Mark Hart to John Paulson to David Einhorn that profited from the unwind. However, to better understand how a slow-moving mean reversion in prices can turn into a collapse that brings the financial system to its knees, we need to identify the trigger for what was a mass liquidation. The consensus cites the real estate bubble popping as the catalyst, but I find this a shortsighted view, especially since housing prices topped years before Lehman collapsed. The financial crisis didn't happen because housing topped or people quit paying their mortgages. There was a trigger. There was a catalyst.

When Ben Bernanke gave his famous "helicopter speech" in 2002, he probably never dreamed it would haunt him the rest of his career:

What has this got to do with monetary policy? Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Market participants rightly ridiculed this speech and Bernanke was soon referred to as Helicopter Ben for his reference to Milton Freidman's helicopter drop of money to stimulate inflation. So when Bernanke first took the helm in 2006, he no doubt wanted to refute this dovish perception and prove his inflation-fighting moxie. Despite the peak in housing and an obvious deceleration in growth, Bernanke went on to tighten 75bps into an inverted yield curve, citing inflation as the primary risk. This was critical.

In August of 2007, just after the Bear Stearns' hedge funds collapsed, the Bernanke FOMC took a pass at easing policy despite a financial system that was obviously under duress. The policy decision was to keep the funds rate at 5.25%, keeping the Fed's policy bias towards inflation risk.

After emergency meetings with former Treasury Secretary Robert Rubin, macro hedge fund manager Ray Dalio, and mortgage market titan John Meriwether, the following week the Fed suddenly had a change of heart and immediately lowered the discount window rate, changing the direction of the policy bias to one leaning toward growth.

Over the next six months, the Bernanke Fed would launch a historic easing campaign in an effort to provide liquidity to the banking system. The market responded by raising inflation risk premiums. The dovish Bernanke they thought they had in 2006 had finally emerged. Helicopter Ben was back.

2008 Yield Curves

Once the market got a sense that a massive easing campaign was forthcoming, the dollar collapsed and commodities rallied. In August 2007 the Fed funds rate was still 5.25%, the EURUSD pair was 1.35, and the price of oil was $70/bbl. By March of 2008 as Bear Stearns was collapsing, the Fed accelerated their easing, slashing the funds rate to 2.25% -- well below the 4.0% rate of inflation.

Crude Vs. PPI

With the Fed pushing overnight rates below inflation, risk premiums exploded, which manifested itself in the slope of the yield curve. What was a flat curve from the 2-year through the 30-year in August 2007 soon steepened rapidly with spreads blowing out across the curve. This was a key development because a steep yield curve translated into a steep risk curve.

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