Where Is the Light at the End of the Tunnel?

n the late 1990s, the United States experienced a capital spending boom essentially focused in three sectors—technology, media, and telecommunication. This capital spending boom, along with easy monetary policies (especially following the collapse of Long-Term Capital Management [LTCM] and ahead of Y2K), propelled the NASDAQ up 48 percent annually between January 1997 and March 2000. Between August 1999 and March 2000, the NASDAQ actually doubled. Then in March 2000, the NASDAQ collapsed, and the U.S. Federal Reserve feared that the world was facing deflation and/or recession. Following the collapse of the NASDAQ, the Fed embarked on an aggressive program of rate cuts. It cut the federal funds rate from 6.5 percent to 1.75 percent by yearend 2001 and then to 1 percent by 2003, where it remained until June 2004. Although the economic recovery in the United States officially began in November 2001, almost three years into an economic expansion, as shown in Figure 1 , the federal funds rate remained at 1 percent. This mispricing encouraged investors who would normally keep their money on deposit to do something else with it—that is, either spend their money or speculate with it. In June 2004, the Fed began to increase interest rates in baby steps (never more than 0.25 percent at a time), and the rates reached 5.25 percent by August 2006. By then, however, cracks were beginning to show in the housing market because of the excessive speculation driven by artificially low interest rates.