Tuesday, February 2, 2010

Fault lines [ubs investment research]

What if the Fed ran China's monetary policy?

While the Federal Reserve did nothing to prevent neither the tech bubble of the late 1990s nor the recent housing bubble in the US, the People's Bank of China has just started to adopt a much more prudent approach. n It is still unclear, whether we face actually a real estate bubble inChina.

n However, the recent loan growth figures in China have stirred the Chinese to act preventively. This is something that the Federal Reserve didn't do in the wake of the housing bubble.

In 1997, after hiking interest rates several times and watching the US equity market reach new high after new high in what he famously termed a bout of “irrational exuberance,” former Fed Chairman Alan Greenspan finally threw in the towel. As he explained in his memoirs, published ten years later: “In effect, investors were teaching the Fed a lesson. You can’t tell when a market is overvalued, and you can’t fight market forces.” This was a reversal from the old Wall Street adage, “Don’t fight the Fed.” Greenspan’s admission of defeat was revealing: It underlined how firmly the belief in the righteousness of market forces was anchored among central bankers.

Or was it actually the threat of repeating Japan's experience in the early 1990s that made the Fed reluctant to curb financial excesses? Trying to deflate the immense equity and housing bubble that it helped inflate in the late 1980s, the Bank of Japan overdid its restrictive measures and did
not act quickly enough to reverse monetary policy once the air was out of
the bubble. This led to decades of deflationary stagnation in Japan,
proving in hindsight that dealing with asset bubbles is not an easy task.


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