Fed Determined to Prevent Another Lehman Moment

There were many mistakes made during the housing collapse, 2008 crash, and the subsequent, lackluster economic recovery. Some of the responsible parties included regulators, banks, greedy investors, legislators, and the Federal Reserve. Out of all these parties, the Federal Reserve seems to have learned their lesson and is charting a different course this time around.

During the 2008 crash, one of the Federal Reserve's major mistakes was to keep interest rates too high in 2007 and 2008 even with signs of a weakening economy. During the latter parts of 2007 and early parts of 2008, commodity prices were soaring which was leading to a focus on inflation. In hindsight, it's clear that inflation was a mere blip that was about to be dwarfed by the deflationary wave of a collapsing financial system.

The other major mistake was in September 2008, when along with the US Treasury, the Fed let Lehman Brothers go under. This essentially led to a complete freeze in the financial system, as banks no longer trusted each other. It also led to a loss of confidence overall in the system which compounded economic pain and financial stresses. It also increased the cost of saving the system.

Applying Lessons

This time, the Federal Reserve was much more aggressive in cutting interest rates even at early signs of weakness like dropping inflation expectations or an inverted yield curve. Once the scope and scale of the coronavirus outbreak became clear, the Federal Reserve immediately cut rates to zero. Through these actions, it made it clear to Congress that fiscal policy was necessary and the Fed would support these measures as well.

This is another lesson from the previous crisis when the Fed and Treasury worked together in aggressive and creative ways to save the financial system by backstopping various credit markets and ensuring that companies wouldn't fail due to liquidity issues.

This time, the Fed has been even more aggressive as it is backstopping even more credit markets like corporate bonds, municipal bonds, and even certain high-yield bond markets. The Fed intervention is clear when looking at the corporate bond ETF, iShares Boxx Investment Grade ETF (NYSE: LQD) which is back to February levels even though the economy is much weaker today than two months ago. Additionally, the junk bond ETF (NYSE: JNK) is also only 10% off its previous highs.

Basically, the Fed is doing whatever it can to prevent failures which can lead to negative, domino effects especially when the economy is already in a precarious state. Additionally, companies are faltering due to a public health crisis not due to their poor decisions.

Counterpoint

A fair and valid criticism of the Federal Reserve is that it's creating moral hazard by intervening in markets and not letting the capitalistic process play out by letting weak firms fail. By propping up weak companies, it prevents stronger companies from growing and rewards excessive risk-taking.

This cycle, the Fed has been quite aggressive in meeting any sort of weakness with aggressive intervention. Basically any decline of more than 20% has been met with some sort of intervention. This has been manna for the "buy the dip" crowd and torture for bears.

Although this is unpleasant for people with certain expectations about the boom and bust cycle, it seems to be a new reality. The Fed has decided that intervening early and aggressively is cheaper than cleaning up the mess or having to save the system. And based on evidence from the past decade, there doesn't seem to be any sort of constraint on the Fed when inflation is low.