Fed research staff predicted an equity bubble 25 years ago. What actions will policymakers take if they foresee another one?

Due to the repetitive nature of economic and financial cycles, analysts frequently encounter phases that resemble previous cycles. At the December FOMC meeting of 1999, twenty-five years ago, the Fed research staff delivered a provocative presentation, arguing that parts of the equity market (mainly tech and e-commerce) had showed characteristics of a "bubble". How might policymakers respond today if the Fed staff made a similar argument, considering the aftermath of the tech bubble burst 25 years ago and the fact that many equity price metrics now indicate even more extreme valuations?

Will History Repeat?

The notion that predicting an equity bubble before it collapses is impossible has been debated for a long time. Yet, in today's context, can this remain valid when there is clear evidence of fundamental valuations defying basic principles of gravity, along with cases where lower valuations were linked to a bubble?

It's important to mention that Fed staff cautioned policymakers about an equity bubble in the late 1990s. At the December 1999 FOMC meeting, the Fed's director of research noted that "the market has defied our notion of valuation gravity by posting an appreciable further advance." The research director provided an example of a new IPO to illustrate the market's speculative nature and mentioned that analysts were disregarding fundamental analysis because the only thing that seemed to matter was "momentum." He then doubted whether an additional tightening of 75 basis points in the staff forecast would be sufficient to "halt the financial locomotive".

From a market perspective, 2024 differs from 1999. In certain instances, equity valuations today are as high, if not higher, than they were in 1999. For instance, the S&P price-to-sales ratio is over 3 today, compared to 2 in 1999, which at that time was a record. This higher ratio indicates even greater investor optimism or exuberance, suggesting potential fundamental instability as people are paying excessively for future sales and cash flow. Although the IPO market does not exhibit the speculation seen in 1999, there are other signs of market speculation in cryptocurrency and private credit.

Additionally, there is a significant contrast between the monetary and fiscal policies of 2024 and those of 1999. In 1999, monetary policy was being tightened, whereas recently, policymakers have reduced official rates at the last two meetings and signaled further easing. At the same time, fiscal policy was restrictive in 1999, with the US achieving a budget surplus, which stands in stark contrast to the current large budget deficit that boosts domestic spending and liquidity.

Drawing from past experiences and research, it would not be big surprise if the Fed staff made a presentation at the December 2024 FOMC meeting similar to that of December 1999. Essentially, market speculation has reached "bubble-like" levels, skewing resource allocation, pushing the wealth-to-income ratio to unprecedented heights, and posing a major economic threat should there be a significant drop in the equity market. The main question is whether policymakers will heed this warning.

Policymakers have consistently made official rate decisions with a focus on employment and inflation goals, often neglecting their financial stability mandate. It's no coincidence that the recessions since 2000 (excluding the pandemic-driven recession) were triggered by financial imbalances. Any decision to ease policy, or even a promise to ease later, would increase the risk of a harder landing that might be difficult to cushion, unlike in 1999 when the US operated with a fiscal surplus.

Regardless of the actions policymakers decide on, they can no longer ignore a speculative asset price cycle like they did in December 1999. Policymakers are fully aware of the economic and financial losses that come with asset price imbalances. When the tech bubble burst three months later, the Fed spent the next three years lowering official rates to lessen the economic impact of the financial crisis. After the housing bubble burst, the process took even longer. Currently, the Fed is confronting a larger and more extensive financial bubble, with no fiscal cushion to help navigate a severe recession.