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With the global economy improving, central banks need to be ever watchful, and tighten policy in good time, to ensure siren calls on asset bubbles continue to ring hollow, says Michael Grady.
In recent weeks, officials at the US Federal Reserve (Fed) have sounded concern about asset prices, which in the words of the central bank’s chair, Janet Yellen, appear “somewhat rich”. 1 So far, financial markets have been content to turn a blind eye. Stock markets in the US and elsewhere are at or near record levels, while US Treasury bond yields are below where they began the year.
While the Fed is probably not unduly alarmed by the level of asset prices just yet, the remarks from Yellen and others add another element to the debate around the pace at which US interest rates should rise. It reinforces our belief that market expectations that rates will be hiked just three times over the next four years are likely to prove misplaced. The Fed itself expects to raise rates on four occasions – by a cumulative one percentage point – by the end of 2018. It says tighter financial conditions are required to ensure unemployment does not fall too far and inflation rise too much. But when making that assessment, the Fed rightly also says it needs to take into account the overall state of financial conditions and risks to financial stability.
Despite having raised rates by 0.25 per cent on four occasions since December 2015, financial conditions have become easier over this period, thanks to soaring equity valuations and plunging credit spreads – both the dollar and long-term interest rates are little changed. Furthermore, it seems many investors believe the central bank will be unable to tighten policy much further without negative repercussions for the economy.
We do not share this view. Monetary policy remains highly accommodative, with negative real rates still prevailing. Failing to raise rates expeditiously poses a greater risk to the economic outlook as it could mean the Fed having to hike more aggressively down the track.
Talk is cheap
Although there have been plenty of occasions in the past when Fed officials have talked about frothy asset markets, they have shied away from actually taking the necessary steps to prevent bubbles expanding, preferring to try and clean up the mess after they burst.
As former Fed Chairman Ben Bernanke said in 2002: “Understandably, as a society, we would like to find ways to mitigate the potential instabilities associated with asset-price booms and busts. Monetary policy is not a useful tool for achieving this objective.”2
Like the global financial crisis, the origins of the dot.com bubble of the late 1990s can be traced back to loose monetary policy. To be fair to Alan Greenspan, Bernanke’s predecessor, he had voiced concern about stock prices long before they had peaked in a famous speech in December 1996. Furthermore, transcripts of subsequent meetings of the committee that sets US interest rates revealed several officials had expressed anxiety about a possible bubble in 1998 and 1999.
The bottom line, however, is the Fed did precious little to deflate it until it was too late. At 4.75 per cent, the Federal Funds rate was 50 basis points lower in June 1999 than it had been fully two and a half years earlier when Greenspan first warned of the stock market’s “irrational exuberance”.
In the past, Fed officials advanced three main arguments for not using interest rates to control asset prices. First, they said the best way to achieve economic stability was to focus on inflation and growth when setting monetary policy. Asset prices only mattered to the extent they impacted wider economic activity and consumer prices. Second, one can never be sure that what looks like a bubble really is a bubble. And third, interest rates are too blunt a tool to control asset prices. A modest rise in rates is unlikely to halt rising asset prices, but an increase sufficient to pop a bubble would slow the whole economy. They concluded it was safer to wait for a bubble to burst by itself and then ease monetary policy to moderate its after-effects.
Taking each of these arguments in turn, excessive asset price inflation can lead to a misallocation of resources – either too little saving or too much investment in a particular area of the economy. Furthermore, if the asset bubble is accompanied by excess credit growth, systemic financial risk rises as well. As was seen in 2008, the cost of such a debt-fuelled bubble bursting may simply be too great for monetary policy to be able to effectively clean up. Arguably over the past 20 years or so, weak goods-price inflation has led central banks into keeping rates so low that excess liquidity has encouraged excessive speculation.
As for the second argument, it is true that determining whether or not a bubble exists is difficult. Predicting when it might burst is harder still. But that is not an excuse for doing nothing. While it may be impossible to identify bubbles with total certainty, there are indicators that should provide some level of warning. For example, when certain asset prices are clearly out of line with underlying fundamentals or there is a rapid expansion of credit growth, questions need to be asked. Policymakers live in an uncertain world. Uncertainty is a reason for responding cautiously; not for failing to respond at all.
While it may also be true interest rates are too blunt a tool to deal with asset prices, nobody is suggesting central banks should target a particular level of asset prices. Most economists would accept that aggressive action to prick bubbles is risky. Rather, the debate revolves around whether central banks should ‘lean against the wind’ when debt and asset prices appear dangerously out of line with fundamentals.
As former Fed Governor Jeremy Stein argued, monetary policy has the advantage of getting “in all of the cracks”, something that ‘macro-prudential’ policies may not succeed in doing. 3 Tightening monetary policy in an asset boom is akin to buying insurance against a later risk of a larger economic bust. The cost of some short-term loss of output must be set against the risk of larger future losses.
In any case, perhaps the biggest argument for central banks to respond to excessive asset-price inflation is that failing to do so risks creating a moral hazard. If a central bank always cuts interest rates when asset prices tumble, but is reticent to raise them when financial markets recover and risk premia fall back, investors will be encouraged to take ever bigger risks. While the Fed was no doubt sensible to ease policy aggressively when the credit bubble burst in 2008, after almost a decade of extraordinarily loose policy there is a risk of inflating another.
The Fed’s dilemma
All of which begs the question: will the Fed be willing to tighten policy in a timely fashion, partly in order to reduce the risk of a future credit-fuelled asset price bubble, or will it err on the side of caution and continue to raise rates at a slow pace as the market believes; potentially creating an even bigger problem down the track?
Determining the Fed’s likely course of action is far from easy; not least because recent statements have not always been consistent. Furthermore, we believe officials will be far more comfortable trying to talk asset prices down than taking concrete action were they to suspect the formation of bubbles.
However, we would draw a distinction between the last two stock market crashes. Arguably Greenspan was unfairly maligned for having created the so-called ‘Greenspan put’ in the late 1990s. Since the rally in stock prices was not accompanied by excessive amounts of leverage, the recession which followed the bursting of the dot.com bubble was quite shallow.
The same could not be said for the housing market bubble eight years later. Since it was accompanied by the build-up of unsustainable amounts of debt, its bursting had devastating effects on the economy.
The lesson here is that the Fed will need to be on its guard for any signs of excessive leverage building up in the system. While we don’t believe that yet to be the case, there are areas of concern which merit close attention. Yellen and her colleagues have little room for complacency.
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