Fed Knows It's Too Risky to Curb Market Bubbles by Hiking Rates

The risk of financial instability associated with high asset prices alone currently does not affect monetary policy much, if at all.

Markets are looking like a bubble.

Photograph: AFP

Be wary of concerns that looser financial conditions will prompt tighter monetary policy from the Federal Reserve. The actual response will be much more nuanced.

Market participants, sometimes encouraged by policy makers, often focus on the possibility that stocks will become overvalued and prone to destabilizing price declines if interest rates stay “artificially” low. Chair Janet Yellen said in June that asset valuations look “somewhat rich.” A persistent period of low rates -- “artificial” or not -- elevates these concerns. From Fed Governor Lael Branaird:

 It is worth considering the possible implications of a sustained period of low neutral rates and low unemployment for financial imbalances. Historically, extended periods with very low unemployment rates tend to be associated with below-average spreads of expected returns on risky assets over safe interest rates -- low bond risk premiums, for example, or low equity premiums.

Thus, in today's environment, it is important to be vigilant to the signs that asset valuations appear to be elevated, especially in areas such as commercial real estate and corporate bonds, as well as the exceptionally low levels of expected volatility.

The Fed can’t ignore the issue given asset price behavior during the last two cycles. It needs to at least pay it lip service, and some policy makers will take it more seriously than others. For instance, Boston Federal Reserve President Eric Rosengren specifically referred to the stock bubble of the 1990s in a speech this week.

But the risk of financial instability associated with high asset prices alone currently does not impact Fed policy much, if at all. Hiking rates to rein in asset prices is just too risky a strategy. Policy makers don’t know to what extent fundamental factors account for recent asset-price gains and they do not want to inadvertently cause a recession chasing a nonexistent “bubble.”

Still, high asset prices alone are not the whole story when assessing financial instability risks. Back to Brainard:

Nonetheless, there are few signs of a dangerous buildup of leverage or of maturity transformation, which have traditionally been important contributors to financial instability. 

Yellen echoed these sentiments in her speech this week. While reiterating the logic of the Fed’s gradual tightening strategy, she said:

Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability. 

Policy makers are generally uneasy about the financial risks associated with a low rate environment, but these concerns center more on risks that could lead to a systemic collapse of the financial system, such as high levels of leverage, rather than high asset prices by themselves. Although they currently rely on greater regulatory control (Brainard mentioned that specifically) to contain any potentially disruptive behavior in the financial system, they would very much like to be in a higher-interest-rate environment to mitigate this possibility.

The concern still doesn’t rise to the level of forcing a faster pace of rate hikes, especially because central bankers do not yet perceive a buildup of systemic risks. Brainard recognizes the risk, yet still wants more evidence of inflation before increasing again. Yellen seems driven to boost rates now primarily to avoid the possibility of a faster pace of hikes in the future.

If richly valued assets or concerns about systemic risk are not driving policy, do financial conditions matter at all right now? Yes, via the implications on the economic outlook. The Fed anticipates that raising short-term rates will lessen financial accommodation. But the opposite has been the case -- higher equity prices, a falling dollar, tighter credit spreads and a declining long-term bond yields. New York Federal Reserve President William Dudley is particularly wary of the implications:

The easing in financial conditions is important because monetary policy does not directly influence the trajectory of economic growth and inflation. Instead, as I have noted in previous remarks, short-term interest rate changes are an important factor that affects broad financial market conditions. Financial conditions, in turn, influence the demand for goods and services by households and businesses. But, if financial conditions ease even as we are removing monetary policy accommodation, this may have implications for further policy adjustments. All else equal, an easing of financial conditions may warrant a somewhat steeper policy rate path. 

This approach to financial conditions, in which asset prices are only part of the story, is most important for policy makers, with clear implications for rate policy. By raising rates, central bankers hope to prevent an overheated economy. They will not be successful if financial conditions ease instead; hence they need to maintain upward pressure on rates. This should be the primary focus of market participants when assessing the likely path of monetary policy.

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