As bullish investors celebrate new record high closes for U.S. stocks earlier this week, a lingering concern is that we may be in the midst of a massive asset bubble created by the Federal Reserve, through its policy of quantitative easing (QE) that has pushed real interest rates down to historic lows. Now the Fed itself is expressing qualms about this policy. "A few participants observed that the appropriate path for policy, insofar as it implied lower interest rates for longer periods of time, could lead to greater financial stability risk," according to the minutes of the Federal Open Market Committee (FOMC) from its March 19-20, 2019 meeting.
"There are reasons for fearing the economic consequences of very low’’ rates, warned former U.S. Treasury Secretary Lawrence Summers at a recent conference, as quoted by Bloomberg. “These include a greater propensity to asset bubbles’’ and “incentives to substantially increase leverage,’’ he added. Tobias Adrian, director of the Monetary and Capital Markets Department at the International Monetary Fund (IMF), expressed a similar view at a Boston Fed conference in 2018. “Easy financial conditions today are good news for downside risks in the short-term but they’re bad news in the medium term,” he said, as quoted by Bloomberg.
The table below summarizes recent public statements made by Fed Chairman Jerome Powell on these matters.
The Fed Chairman's View
- The last two U.S. economic expansions ended in asset bubbles, not inflation
- These were the dotcom bubble and the housing bubble
- The Fed does not see a high risk of financial instability now
- Bank capital requirements and stress tests are keeping the system safe
Significance for Investors
To combat the 2008 financial crisis and pull the economy out of recession, the Fed embarked upon an unprecedented policy of quantitative easing (QE) that sent real interest rates down to historic lows, propping up financial asset prices in the process. The bear market of 2007-2009 had sent the S&P 500 down by 50.9%. Prior to that, the popping of the dotcom bubble resulted in the S&P 500 tumbling by 44.7% from 2000 to 2002, while the tech-heavy Nasdaq Composite Index plummeted by 76.8%.
The Fed's main goals right now, based on its public pronouncements, are to keep the economy expanding at maximum employment while also keeping inflation in check, at no higher than a 2% annual rate of increase. Some observers feel that the Fed's recent dovish turn, announcing a pause in interest rate hikes, is partly the result of jawboning by President Trump, who has complained that rate increases were causing unnecessary harm to the economy and the market.
"I do see some parallels between the 1995-96 period and what we're currently in," as David Stockton, a former director of the Division of Research and Statistics at the Fed, told Bloomberg in another story. He noted that, back then, the Fed decided that it had "overdone it" with rate increases, prompting it to reverse course by cutting rates. The Fed is widely expected to keep rates steady at its next meeting, scheduled to take place from April 30 to May 1. "I think they stay on hold here for a long time, but there is a risk that lower inflation does push them to think about easing," as Bruce Kasman, chief economist at JPMorgan Chase & Co., told Bloomberg.
Among the downsides of a loose money, low interest rate, policy is that investors desperate to increase yields and returns are compelled to seek out ever-riskier investment options. Among those who disagree that systemic risk has increased is legendary fund manager Bill Miller. In a recent letter to clients, he argues that the market is still gripped by excessive fears spawned by the 2008 crisis, and that "real risk" is much lower than "perceived risk."
"Financial stability risks could be addressed through appropriate use of countercyclical macroprudential policy tools or other supervisory or regulatory tools," per the FOMC minutes. Indeed, it is likely that Fed will reverse course again and hike rates if either the economy or the markets begin to show signs of excessive froth.