The long shadow of the Y2K bug

Remember the concerns during the years before the end of the twentieth century about the "Y2K bug" that threatened to cause airplanes to drop from the sky, nuclear plants to melt down, and electronic data systems and power grids around the world to fail, leading to riots, confusion, and chaos?

It seems almost laughable now, but if you were a bank employee or a member of the Federal Reserve (which has oversight of banks), your recollection of Y2K would be that getting ready for it was no joke. The Fed took the threat of y2K problems very seriously, and conducted extensive preparation for the event in the months and even the years leading up to January 1, 2000.

You might think that Y2K came and went with no ill effects, but you would be wrong. That's because, as we have written before, the effects of Fed oversteering on the economy are enormous.

Look closely at the graph above, which shows the Federal funds target rate in red, superimposed on a graph of the NASDAQ Composite Index in blue, from the middle of 1995 to the present. During the year 1999, the Fed lowered rates dramatically.

To a casual observer, the rate cuts of 1999 may not look that dramatic -- especially in light of the truly historic rate cuts that follow later in the chart -- but if you understand that even a small move of 0.25% in the Fed funds target rate is a major event on Wall Street and the broad economy, with a huge impact on lending and investment and business activities, you will realize that the successive rate cuts of 1999 were actually very significant -- especially because they came at a time when the economy was already on fire and dot-com mania was blazing.

The significance of this excessive money creation is graphically shown by the reaction of the NASDAQ Composite Index on the same graph. Dramatic Fed easing typically results in "malinvestment," or the misallocation of capital due to an artificially altered perception of risk. When money is made too cheap and too plentiful, excesses occur which are commonly called "bubbles." In 1999, as everyone knows, that bubble was in speculative companies found mainly in the NASDAQ Composite. The Fed's 1999 rate cuts poured gasoline on the fire, ending in the NASDAQ flaring to 5048.62 on March 10, 2000.

We believe that this should never have happened -- it was the Fed's ill-timed panic over Y2K and attempt to flush the system with extra cash in advance of it (see for example this article or this article from May and June 1999, with the Fed banks "stocking the vaults" with seven to eight times normal cash amounts, and saying they "stand ready to lend" as necessary) which resulted in a rush of speculative buying in what was hot at the time (telecom and tech-related companies).

Alarmed by the dramatic bubble that they created, the Fed rapidly and excessively tightened rates, resulting in an even more dramatic collapse of the bubble. Unfortunately, the tightening (far beyond the level rates had been before the cuts) came at a time that the economy was beginning to slow, resulting in the biggest deflation since the 1930s, decimating the overleveraged telecom and overextended tech sectors (exacerbated by the previous excessive loosening).

As we have said before, it is this volatile monetary policy which has created the extreme boom-and-bust cycles that have continued since 2000 and resulted in what many are calling a "lost decade" for stocks (major indexes in 2008 are roughly where they were in 1998).

Since then, the Fed has continued this pattern of dramatically oversteering, leading to the housing and mortgage bubbles, which also clearly took off after a period of dramatic Fed easing just as the NASDAQ bubble did, this time beginning with the thirteen-month period when the Fed held their target rate at 1%, seen at the lowest portion of the red line in the graphs above.

The housing and mortgage collapse is still reverberating through the financial sector. In response to its ill effects, the Fed has rushed to the "rescue" just as they did after the NASDAQ bubble, with the most recent series of rate cuts (seen at the right end of the red graph).

This latest overreaction is responsible for the commodities bubble and high gasoline prices of 2008, as well as the inflation that is becoming harder and harder for "inflation doves" to deny. The speculation occurs in whatever asset is hot at the moment -- from 2003-2006 it was real estate and mortgage securities; today it is in commodities.

The Fed's excessively volatile monetary policy destroys the stability that is most conducive to business growth and economic progress. The technological advances that began prior to the NASDAQ bubble and which characterized the growth of the late 1990s are continuing today, but not with the same kinds of benefits and progress we might have seen by now if the Fed had provided an environment of stability instead of the chaos created by their oversteering.

This is the real legacy of the all-but-forgotten "Y2K bug" fever of 1999, and a pattern that we hope future Fed Chairmen will realize and reject.

For later posts on the same topic, see also:

• "Revisiting the 'New Economy'" 05/06/2009.

• "Stand still, little lambs, to be shorn!" 06/03/2009.

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "The Bandwidth Revolution" 07/29/2009.

• "What Rube Goldberg could teach us about economics" 12/08/2009.

• "The 97-pound weakling" 12/16/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "Was the decade lost?" 01/14/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Great minds think alike!" 03/19/2010.

• "Why do we want the Fed to steer the economy?" 09/01/2010.

• "Likelihood of Fed over-steering increases" 01/25/2011.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.