If booming asset prices go bust, the central bank’s credibility would be severely damaged.
by Phillip Swagel, Professor in International Economic Policy, Maryland School of Public Policy and Academic Fellow, Center for Financial Policy and Marc Sumerlin, Managing Partner at Evenflow Macro
This post was originally published as an Opinion in the July 17, 2014 edition of the Wall Street Journal which can be found here.
Federal Reserve Chair Janet Yellen in her testimony on Capitol Hill this week was candid, as she has been in the past, in telling lawmakers that the biggest economic risk she sees facing the country is the possible emergence of a new permanent class of unemployed workers.
To head off this possibility, the Fed is holding monetary policy accommodative longer than traditional monetary models would recommend. Opinions on the wisdom of this policy are split, but the Fed’s openness about its policy is heralded almost universally as a desirable development.
We are not so sure.
In today’s world the heads of the central bank determine what is immediately deemed common knowledge, and only investors with long time horizons (and a strong stomach) can resist their pronouncements. Ms. Yellen sees considerable labor-market slack, believes this will hold down inflation, and therefore pronounces that the Fed’s near-zero interest-rate policy will continue far into the future. The conventional wisdom is that low rates and low inflation are consistent with an environment in which asset prices rise, so that is what has happened.
This is now the third episode in the past 15 years in which asset-price growth has significantly outstripped income growth. From 1997 to 2000, the net worth of American households rose 40% while national income grew 20%, and in 2002-07, net worth grew 60% as national income grew 30%. Asset prices corrected after each of these rapid increases.
Janet Yellen, chairman of the U.S. Federal Reserve, from left, and Federal Reserve governors Daniel Tarullo, Sarah Bloom Raskin, Jeremy Stein, and Jerome Powell attend an open meeting of the Board of Governors of the Federal Reserve in Washington, D.C.., on Feb. 18, 2014. Bloomberg News
Over the past two years, net worth has grown more than 20% (a similar annual pace as the past two episodes) during a period when national income struggled to grow 6%—and interest rates are still near zero. When the Federal Reserve signals that monetary conditions will remain easy, behavior shifts and a self-fulfilling rise in asset prices is the result.
On Tuesday the Fed stated in its semiannual Monetary Policy Report that valuations were “substantially stretched” in some sectors like biotechnology and social media. Ultimately, however, asset prices should reflect expectations of future income, making them vulnerable to correction when they become too high relative to income.
A problem of having too much certainty on monetary policy is that once the market has come to accept the Fed’s views, changes in the story can be unnecessarily disruptive. Harvard economist Jeremy Stein, a former Fed governor and its leading thinker on financial stability before returning to teaching at the end of May, articulated in his final speech why the Fed’s change in rhetoric in the spring of 2013 was so disruptive.
Mr. Stein noted that a number of investors perceived that quantitative easing would essentially last forever, and they repositioned abruptly when then Fed Chairman Ben Bernanke suggested the program could be finished in a year’s time. The Fed is not responsible for investors who take losses, but the centrality of monetary policy to investment returns leads people to put too much weight on their predictions of Fed actions and too little on fundamental analysis of individual investments.
Mr. Stein warned that “the market is not a single person” and that there might be a similar event if the Fed alters its view on interest rates. This is the big risk for the market now. Ms. Yellen has successfully defined conventional wisdom as a future in which the Fed keeps overnight rates near zero even while inflation and employment approach their respective targets. Indeed, the success of the Fed’s communications in convincing investors that rates will remain low has contributed to low volatility across asset classes, encouraging yet higher valuations. If there is less slack than the Fed believes, monetary accommodation will reverse at a more rapid pace than markets expect.
Imagine a swimmer drifting easily with an ocean current who suddenly discovers he is a long way from shore. Asset prices could be in for a sharp correction. If the U.S. economy were to go through another asset bust cycle, the Fed’s credibility would be severely damaged, and its strategy on reducing unemployment would backfire.
Many monetary experts refer to the 2000 equity crash as a benign event. But the unemployment rate rose by 2½ percentage points after the decline, and the monetary policy response to that rise in unemployment contributed to the housing bubble and the 2008 financial crisis. The Fed will not achieve the stability that it seeks until financial stability concerns are given an equal weight when determining monetary policy.
Mr. Sumerlin, former deputy director of the National Economic Council (2001-02), is managing partner of Evenflow Macro, where Mr. Swagel, former assistant secretary of Treasury for economic policy (2006-09), is an adviser.