The Fed's Forever Blowing Bubbles—and Thinks, Again, That's Okay
07/07/2014 4:48 pm EST
Even though Janet Yellen’s repeated reprise last week pleased a number of analysts and seemed perfectly timed with the market’s rally, MoneyShow’s Jim Jubak still has some doubts.
Just before the Fourth of July holiday, on July 2 to be exact, Federal Reserve Chair Janet Yellen repeated her view that rather than trying to pop bubbles in asset prices, the Fed should work to make sure that financial institutions are in good enough shape to withstand the effects of rapid deflation of a bubble.
Now Yellen has said this before, and hers isn’t an isolated opinion at the Fed. But the timing of her reprise of the Fed won’t pop bubbles was fortuitous. US indexes that had been trading at all time highs popped higher in the sessions that followed. The Dow Jones Industrial Average closed above 17,000 for the first time ever.
Now, certainly, there were other reasons for the rally—the US economy added 288,000 jobs in June, up from a revised 224,000 jobs in May. And it is reasonable to conclude from those numbers that the US economy is picking up speed.
But, still, there is nothing more reassuring to an asset market that is perched at all time highs than to know that the Federal Reserve doesn’t see those high prices as a reason, in themselves, to start raising benchmark interest rates earlier than now expected. (On Monday, July 7, Goldman Sachs joined JPMorgan Chase and Bank of Tokyo in moving up predictions for when the Fed will start raising interest rates to the third quarter of 2015 from the first quarter of 2016. But that move was based on a forecast of greater strength in the US economy after the jobs numbers).
The Fed has been trying to come up with a policy on assets bubbles ever since it took big flack for failing to act in the run up to the dot.com crash that led into the bear market that began in March 2000.
The question has taken on new urgency as the Fed’s balance sheet has topped $4 trillion as a result of pumping money into the financial system in the wake of the sub-prime/Lehman Bros. global financial crisis. Before the crisis, the Fed’s balance sheet was around half a trillion dollars. Cheap money from the Fed, the European Central Bank, the Bank of Japan, and the People’s Bank of China is widely credited with producing the current bull market in financial assets. And that has, in turn, produced a certain anxiety whenever traders and investors think about how/when/if central banks are going to reduce those balance sheets. That anxiety was the cause of the May 2013 “Taper Tantrum,” when then Fed chair Ben Bernanke sent global markets—especially emerging markets—plunging when he said that the Fed would begin tapering off its $85 billion in monthly purchases of Treasuries and mortgage-backed assets later in the year.
Since then, fear of the Taper has gone away as the Fed has cut its purchases month by month (with an end in sight this year) without crushing markets or asset prices.
The Fed, under both Bernanke and Yellen has also made it clear that the US central bank isn’t looking to tackle its bloated balance sheet any time soon—if ever. So take that worry off the book in the short-term, at least.
With those two worries off the books what remains is anxiety about when the Fed will start raising its short-term benchmark interest rates from the 0% to 0.25% range where they are now and have been since December 2008.
The Fed has said it intends to keep rates at this low level until the economy shows sustained growth. The market believes that means until mid to late 2015 or early 2016 based on relatively tepid (even after June’s 288,000 net new jobs) job growth, a lack of inflationary pressure, and worries about fiscal policy in Washington.
The big wildcard that could upset that consensus view is a decision to raise interest rates sooner in order to head off or break an asset bubble.
That danger is what Yellen looks to have taken off the table on July 2—again.
Yellen said, "I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment," although she did point to unusually narrow corporate bond spreads, a lack of financial volatility, and weak lending standards in the leveraged-loan market as areas of concern. To combat those potential problems, Yellen said, regulators need to add regulation and oversight that would “enhance resilience within the financial system” in order to contain the damage from bubbles when they pop. Using interest rates to pop bubbles isn’t practical, she argued, because it would require significant increases in rates that would produce an unacceptable slowdown in growth and a very large increase in unemployment.
I don’t know whether Yellen’s position makes you feel all warm and cozy.
Me? I’ve got some doubts. I doubt, for example, that the Fed’s regulators—who were asleep at the switch during the run up to the sub-prime mortgage crisis—are going to be able to strengthen the financial system so that it can withstand everything an unspecified bubble-popping crisis can throw at it.
I also find it curious that Yellen would say that, hypothetically, raising interest rates to head off a bubble would cost too much in potential growth and jobs, when it’s clear that not raising rates—to head off the Global Financial Crisis and the Dot.com bubble, for example—resulted in huge costs in potential growth and jobs. I have to wonder if this policy isn’t simply an excuse not to tackle the problem of the Fed balance sheet—and to avoid having to say that the balance sheet problem is intractable.
Dow 36,000, anyone?