Root cause of asset bubble
The Fed fund were kept low for too long
It all started in 2000 when Federal Reserve chairman Alan Greenspan; faced four challenges that caused near deflation.
- Bursting .com bubble in March 2000
- Cyclical recession in March 2001
- 9/11 Attacks that generated 40 billion in insurance losses and 7.5% stock decline in one day and closure of the stock market
- China membership to WTO in Dec 2001 that opened the market to the cheap labor that put downward pressure on prices ever since
The customer CPI in 2001 was 1.5%, the lowest since 1986. The CPI rosed to 2.83% in 2002 but dipped again to 1.88% in 2003. In response, the annualized effective Fed fund rate declined from 6% in Jan 2001 to 1.8%.
Greenspan kept fund rate below 2% till Feb 2004 to stop the deflation. However, the three years stretch of sub 2% Fed funds 2001-2004 was too low too long. Cheap money flowed into the housing market and resulted in the housing bubble and subprime mortgage crises that exploded in 2007.