Financial Stability Needs Rules Too!

The sharp sell-off in equity prices is no reason for the Federal Reserve to abandon its plan to continue to raise official interest rates, but it does highlight the need for policymakers to offer better clarity, if not establish some guidelines, on its role in maintaining financial stability.

Business cycles have become increasingly dominated by asset price cycles such that financial stability has become more than an equal alongside full employment and stable prices in the objectives of monetary policy. As a result, policymakers may need to set some rules and be willing to use the interest rate lever, which has been traditionally used for fighting inflation, to address excessive asset valuations and easy financial conditions so that a quick unwind of the financial cycle does not destabilize the economic cycle as it did twice before.

Monetary policy has long been focused on the economic cycle because of its dual mandate of full employment and price stability. And in recent years policymakers have altered the policy framework to include specific price targets as well as communicate its policy objectives through its economic and official rate forecasts. The maintenance of price stability is believed to be paramount for a successful monetary policy and policymakers believe by publically setting a specific price target (in this case a 2% increase in consumer price inflation) it provides an anchor to the public’s price expectations.

Yet, people’s expectations of price inflation are largely driven by local events and experiences. As a result, it is hard to see how there is any “herding” of consumer price expectations based on the Fed’s official target and that the fact that the sum of the local inflation results add up to something close to aggregate consumer price target of 2% is based on more luck than design.

Monetary policy appears to have a more direct impact on price expectations in the asset markets where there is clear evidence of “herd behavior” among investors. And recent changes in monetary policy operating framework appear to have increased the “herding bias” in the asset markets.

For example, as policymakers have become more transparent and communicate their economic forecasts as well as the scale and timing of policy rate changes the risk of investing has been greatly reduced since the odds of a potential negative “policy surprise” have been cut to almost zero. Policymakers have also shown consistent bias of responding with a lowering official rates when there is a sharp and sustained decline in asset prices, and conversely have not used the interest rate lever when asset prices have risen a lot over a period of time. All of this invites lowered risk premiums while encouraging speculation in riskier assets.

No one is arguing that policymakers establish a “speed limit” to asset prices, but two asset bubbles in the past 20 years indicate that there needs to be an increased focus on financial conditions and the elevated level of asset prices. Lessons from past asset bubbles offer some guidelines when asset markets have become unhinged and “frothy” and therefore become a key risk to the economy at large.

At the end of the third quarter, for example, the market value of household real and financial assets reached two record highs; 6.1 times the level of nominal GDP and over 700% of disposable income, far exceeding the prior peaks recorded during equity and housing bubbles. These elevated level of asset vales should at least send a ‘warning signal” to policymakers that by holding official rates at very low levels for an unprecedented period they inadvertently created too much liquidity and too easy of financial conditions.

Policymakers have long argued against using the interest rate lever to address rich asset valuations (bubbles), as they believe it would cause too much damage to the general economy. Yet, the evidence to suggest that policymakers can’t use the interest rate lever to address frothy financial conditions and asset bubbles without causing substantial damage to the economy is sketchy at best, but there is hard evidence (two recessions) of what happens to the general economy if policymakers let asset price cycles driven by excessive liquidity go unattended.

As the nature of economic and finance cycles have changes the conduct of monetary policy has to involve and incorporate more elements of risk management in its deliberations, and not just base policy decisions on the dual mandate of full employment and price stability. Policymakers would be wise to establish some guidelines on its role in maintaining financial stability and be willing to use the interest rate lever in the pursuit of financial stability.

In his speech at the Federal Reserve Bank of Kansas City symposium at Jackson Hole in August Federal Reserve Chairman Jerome Powell stated, “In the run-up to the past two recessions, destabilizing excesses appeared mainly in the financial markets rather than in inflation.” The fact that the market value of household assets relative to income and output has already surpassed the peak levels of the past two cycles suggest potentially destabilizing excesses already exist.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.