Former Fed Governor Predicts “Wrenching” Market Adjustment

by Wolf Richter, Wolf Street

Lawrence Lindsey, a Governor of the Federal Reserve from 1991 to 1997, was right before. And got fired for it. Reality was too inconvenient.

In December 2002, as George W. Bush’s economic adviser and Director of the National Economic Council at the White House, he fretted out loud that the invasion of Iraq would be a lot more expensive than supporters of it were claiming. Clearly he’d failed to drink the Kool-Aid. Instead of peanuts, it would cost as much as $200 billion, he said. It shook the White House at its foundations, the fact that he had the temerity to say this.

The Atlantic explains:

Bush instead stood by such advisers as Paul Wolfowitz, who said that the invasion would be largely “self-financing” via Iraq’s oil, and Andrew Natsios, who told an incredulous Ted Koppel that the war’s total cost to the American taxpayer would be no more than $1.7 billion.

As it turns out, Lawrence Lindsey’s estimate was indeed off — by a factor of 10 or more, on the low side.

So maybe people should listen to him. And maybe, if his record repeats itself, the disaster he warns about is going to be a lot more costly in the end than the worst-case scenario he is now predicting.

Lindsey was speaking during a panel discussion on Fed policy at an event sponsored by the Peterson Foundation, MarketWatch reported. And once again, he dared to say what everyone already knew, but what the financial establishment on Wall Street fights tooth and nail: The Fed has dragged out the normalization of interest rates “way beyond what is prudent.”

He explained that in graduate school, if you suggested that the federal funds rate should be kept at zero while the unemployment rate is 5.4%, which is exactly what the Fed has been doing, “you would have been laughed out of the classroom.”

“At some point we’re going to get a series of bad numbers, showing a little higher inflation, and the market is going to say ‘on my god, we’re so far behind the curve’ and force an adjustment that is going to be wrenching,” he said.

According to his calculus, when this “wrenching” adjustment kicks in, it would turn into a market disruption at a level “seven or eight” on a scale of 10, with 10 being the worst.

But that’s the guy that warned that the total cost of the Iraq invasion would be $200 billion, instead of peanuts, and later it turns out to amount to $2 trillion. So by how much is he underestimating the ultimate debacle with his prediction of a “wrenching” adjustment of “seven or eight” on a scale of 10? Maybe we’re better off not knowing the answer.

So what should the Fed do to mitigate the risk of this sort of bone-chilling bond market? Start hiking rates. Start with modest hikes. But start in June.

But it may already be too late. He said the Fed “has almost no credibility” with his clients about its ability to “stay on top of ticking monetary bomb.”

Stocks are at all-time highs. The party is just too fun to walk away from. Money is once again flooding into even distressed energy-related junk-rated companies that are once again able to sell bonds on a wing and a prayer because yield-starved investors, brainwashed by the Fed’s interest-rate repression, are chasing yield wherever they can find it, no matter what the risks.

Times are good, and everyone is having fun now. But it won’t last: “the market is going to take the Fed and the Treasury curve to task in a very painful way,” he warned.

Rate hikes would have a long way to go: If the Fed raised rates by a quarter percentage point at every other meeting starting this June – oh my, can you see the tantrum already? – monetary policy would not actually be restrictive until December 2016, he said.

Going that far, ever, though it would only mean going back to “normal,” would be plain unthinkable for Wall Street hype mongers that have conniptions every time the Fed contemplates raising rates just once, and just a quarter point, just to show that it’s still there, even if it has no intention whatsoever of staying on “top of the ticking monetary bomb.”

A disturbing scenario is already playing out for folks fretting about “financial instability,” as it’s called in central-bank jargon. Read… “Buyers beware”: Capital Markets “Completely Backwards”

Sharing is caring!