The Fed's Mistake

At the January 29-30 Federal Open Market Committee meeting policymakers decided to adopt a “patient posture” arguing that they saw “few risks” in maintaining the current target range for the federal funds. Easy money conditions have created large financial balances that already have the potential to destabilize the business cycle. As such, policymakers face an uneasy trade-off between one economic objective (price stability) and another (financial stability). In hindsight, the decision to risk financial stability may be viewed as a mistake.

Policymakers look at asset prices only insofar as these price movements influence the general inflation trend. That is myopic and misguided on several fronts.

Real estate prices for owner-occupied housing and their cousin “implied rents” were part of previously published consumer price series only to be removed (in 1983 and 1998) when government statisticians argued “bad data samples” biased the accuracy of the measurement. Removing the price signals from the housing market for technical statistical reasons does not mean that real estate inflation is no longer part of the general inflation trend in the economy or suddenly unimportant to monetary policy.

Equity prices, meanwhile, can convey important information about the supply of liquidity, risk-taking and speculation, important factors for policymakers to consider when deliberating on the overall stance of monetary policy.

Asset prices run through the economy and financial markets, creating large gains (and losses during reversals) in nominal wealth to holders of real and financial assets. All of the nominal wealth gains generated during the tech-equity and housing bubbles were lost during the subsequent corrections. In 2018, household financial balances in relation to nominal income hit a new record level, exceeding the peak valuations recorded at the end of the tech and housing bubbles.

The import of large financial balances is not lost on policymakers. At the Federal Reserve Bank of Kansas City symposium at Jackson Hole in August 2018, Federal Reserve Chairman Jerome Powell stated, “in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation.”

Tipping points for asset price cycles can come from a variety of sources or factors. For example, at some point profit rates may fall and not live up to the expectations expressed in equity prices or household may have taken on too much debt and credit markets begin to turn away from extending new loans, or it could come from just a normal tightening of financial conditions.

It is worth noting that as financial balances have gotten larger and larger in relation to income the tipping points have occurred at successively lower and lower levels of interest rates. Official policy rates peaked at 6.5% during the tech-bubble and 5.25% at the peak of the housing bubble. Although it is too early to call a peak in the current cycle there was an alarming “wobbliness” in equity prices in the fourth quarter of 2018 (with prices shrinking nearly 20%) when official rates were only a bit above the 2% mark and perceived to go even higher.

The lower and lower rate threshold suggests the fundamental underpinning for each asset cycle has become weaker and weaker. The fact that equity asset prices were pressured at such a low level of nominal rates is a surprise, but maybe this is one of the unintended consequences of flooding the markets will excess liquidity, via record low rates and asset purchases, for the past decade. At some point, even small reversals in liquidity provisions trigger an out-sized (negative) impact on asset prices.

Downturns can develop from the asset markets themselves, and they can develop quite quickly as evident in the large 1.2% decline in retail sales for December against a backdrop of relatively strong gains in employment and wages.

It is hard to predict what happens next, as easy money "buys" the policymakers time. Yet, the real danger in promising easy money conditions is that it fuels more speculation and risk taking in the asset markets which ultimately threatens the business cycle policymakers are trying to protect. The key question is whether or not this asset price-led business cycle will have a different outcome than the previous two? I have few doubts.

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