Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, reopened an old argument last week about the Fed's role. During a meeting of the Financial Planning Association of Minnesota, Kashkari said that the central bank was keeping its “eyes open for asset prices to try to look for signs of bubbles.” In other words, on top of the Fed’s dual mandate of maximizing employment and stabilizing prices, it may also try to tame high asset prices.
That so-called third mandate won’t be easy to accomplish. For starters, Kashkari has already acknowledged that it’s “very hard to see asset bubbles in advance.” It’s also not clear that the Fed can do anything about frothy asset prices, even if it were able to spot them. But there’s a more fundamental problem: A side effect of the Fed’s dual mandate may actually be inflated asset prices.
The first hint came in the aftermath of the dot-com crash. Unemployment rose from 3.8 percent in April 2000 to 6.3 percent in June 2003. Inflation fell from 3.8 percent in March 2000 to 1.1 percent in January 2002. The Alan Greenspan-led Fed responded by dropping the fed funds rate from 6.5 percent in June 2000 to just 1 percent by July 2003.
Everyone knows what happened next -- investors gorged on risk assets. The yield on the Bloomberg Barclays U.S. Corporate High Yield Index fell from 13 percent in April 2001 to 7.9 percent by June 2007. The yield on the FTSE NAREIT Equity REITs Index dropped from 8.8 percent in November 1999 to 3.4 percent by January 2007. (Yields and prices move in the opposite direction.) The cyclically adjusted price-to-earnings, or CAPE, ratio for U.S. stocks actually declined from its dot-com era high of 44 to 27 in mid-2007, but it remained well above its long-term average of 17.
In fairness, it’s not entirely clear that Fed policy inspired the animal spirits of that era. For one thing, the dot-com crash didn’t dampen sentiment much. And by the end of 2003, the University of Michigan Consumer Sentiment Index had nearly recovered to its pre-crash levels. It doesn’t seem as if investors needed much inducement to chase risk assets.
The aftermath of the 2008 financial crisis has been notably different from that of the dot-com crash. The similarity, of course, is that that risk assets took off almost immediately after the Ben Bernanke-led Fed adopted a zero interest rate policy. The yield on the High Yield Index dropped from a high of 16 percent in June 2009 to half that by the end of 2010. The yield on the REITs Index, too, fell from 10 percent in February 2009 to 4.2 percent just a year later. And the CAPE ratio climbed from 13 in March 2009 to 22 a year later.
The difference is that investors bought risk assets without any apparent enthusiasm for them. Unlike the dot-com crash, sentiment plunged during the financial crisis -- notching a post-crisis low of 55 in November 2008 -- and remained low for years. The average value of the sentiment index was 72 from 2009 to 2013, when risk assets experienced most of their post-crisis gains. By contrast, the average value of the sentiment index was 87 from 1978 to 2008 (the earliest year for which numbers are available.)
Granted, the brave bargain hunters who bought risk assets during the financial crisis were ebullient about the opportunity. But investors continued to pile into risk assets long after the bargains disappeared, and they explicitly pointed to the Fed to justify their choices. The thinking was that, while yields on junk bonds, REITs and stocks would not have been attractive in a normal environment, they were still a lot better than yields from safe assets like Treasuries or cash.
There are signs beyond those two anecdotes that Fed policy may be moving asset prices. The correlation between the fed funds rate and the CAPE ratio for U.S. stocks has been a negative 0.47 since July 1954, which implies that stocks tend to get richer when the Fed lowers interest rates. Similarly, the correlation between the fed funds rate and the yield on the REITs Index has been 0.67 since January 1972, and the correlation with the High Yield Index has been 0.53 since December 1987. In both cases, the correlations imply that yields fall with the fed funds rate.
Correlation isn’t causation, of course. But rather than hint that it can do it all, the Fed should acknowledge that its dual mandate may conflict with its contemplated third one.
It should then appeal to investors’ better judgment by conceding that Fed intervention isn’t free. When the Fed drops interest rates to fight unemployment or deflation, it forces investors to choose between accepting lower yields on safe assets and squeezing more risk assets into their portfolios. The former is a real cost but the latter -- as witnessed twice in the last two decades -- can be devastating.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in Washington at firstname.lastname@example.org
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