The Guest Blog

Farr: A Central Banker's Dilemma

There is a pattern to recessions. Aggregate demand declines, employment falls, production slows, and the economy contracts.  Central bankers, focused on price stability and maximum employment, add liquidity (credit) to the system to counter the decline and stimulate growth.  Risky assets whose very survival may have been questioned at the economic nadir, rebound with remarkable flourish as their near-death experience becomes a distant memory.  The lower interest rates that began at the central bank begin to move through financial institutions, corporations and to the consumer.  Balance sheets reluctantly expand, and in an orderly manner, the central bank will begin to withdraw the additional stimulus and wean the emerging economic toddler.

This recession is among the most significant. The collapse of the credit and housing bubbles has wrought unbelievable consequences. Indeed some twenty months since this recession was declared by the National Bureau of Economic Research (NBER), weekly notices of bank failures continue.  And several prominent banking analysts believe up to 200 more banks may fail by the time this crisis has passed. 

Recent housing data suggest that inventories are beginning to clear as affordability surges on lower prices and mortgage rates. Stock market averages have increased over 50% since the lows on March 9th. Corporate earnings are improving modestly as cost cutting and lay-offs fight the tide of decreasing revenue. The increases in the major market averages have been driven by rebounding “left-for-dead” companies that aren’t dead but certainly aren’t thriving either.  Investors who in March were willing to pay $11 for a share of stock with $1 in earnings are now willing to pay $18.50 per share. But, as we noted, this renaissance of the risky is a normal step in economic recovery. 

There are a couple of problems still worrying me. Most importantly, a troubling dearth of both the supply and demand for credit continues.  Banks are desperately attempting to convince the regulators that they are lending freely, but their balance sheets are not growing.  The securitization market remains a shell of its former existence.  And consumers remain in “pay down” mode as they desperately try to repair the balance sheets that were decimated by the crashing housing and stock markets. A pre-requisite for any robust economic recovery is a rebound in consumer spending, and it still seems unlikely to me given the fragility of the banking system and the new-found frugality of the US consumer. 

My greatest concern is our insistence that this recession and recovery, which have been rife with dozens of new, never-before-seen monetary and fiscal stimulus programs, will follow the scripts of historical precedent.  The central bank’s response to this economic crisis has been brilliant, not without flaws, and powerfully unique. Why should the concluding script of this crisis follow historically grooved patterns when most of our current grooves have never existed before?  It seems a logical certainty that this radically different recessionary experience will lead to some sort of unique recovery.  Moreover, expecting that old patterns will repeat themselves seems a perfect path to disappointment.

Central Bankers have a dilemma.  After the Great Depression a strong price recovery in risky assets was determined to be real by the Central Bank.  Lending standards were tightened in hopes of thwarting renewed speculation and the creation of a new bubble.  But, they got it wrong, and the economy and markets swooned for a “double dip.”  The Federal Reserve Board is walking a very fine line.  If they tighten too soon, we repeat the Depression-era dive or re-learn the failed policy lessons of Japan.  If the Fed fails at their timing, the formation of yet another set of asset bubbles seems inevitable.

Investor sentiment is bullish.  Wonderful feelings of vitality and hope abound after a 50% resurgence in share prices and on the support of increasing home sales.  Stock market price increases have been overwhelmingly based on optimism for a perfect recovery.  I believe that caution is imperative.  If I’m wrong, I’d much rather lose out on an opportunity than lose my clients’ money.

Hang in there,




Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C.  Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.