FEDERAL RESERVE policy makers are embarking on a subtle shift in strategy with potentially big implications for investors: using interest rates as a tool to contain the knock-on effects of lofty stock and asset prices on financial stability and the economy.
The sharpened focus on asset values evident in Fed officials’ public and private remarks suggests the central bank will be more inclined to raise interest rates than otherwise, even if inflation is low. It also means that financial markets can no longer expect – in the words of Allianz SE chief economic adviser Mohamed El-Erian – the Fed to be their BFF, or best friend forever, providing them with unstinting support.
“The financial stability argument for tightening is getting more weight,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore and a former Fed economist.
Led by former chairman Alan Greenspan, central bankers had long argued that they were ill-equipped to spot bubbles in the making and the best approach to tackling them was to let them burst and clean up the mess afterwards. But behind the latest shift is a recognition by officials that the last two recessions were at least partly prompted by declines in markets that had gotten too frothy – technology stock prices in 2001 and housing in 2007.
Fed Chair Janet Yellen hinted at the change last week in laying out her argument for further, gradual interest-rate increases.
Not only does “persistently easy monetary policy” raise the risk of an overheated economy, it “might also eventually lead to increased leverage and other developments, with adverse implications for financial stability,” she said in a speech in Cleveland.
Fed research has shown that such buildups in leverage often occur when risk-taking in markets is elevated – as central bank staffers deem is the case now.
New York Fed President William Dudley, a close ally of Yellen’s, has been more explicit in tying policy to market developments, though his focus has been on their impact on the economy, not financial stability.
Even with three rate hikes since December, stock prices have risen by more than 10% and the dollar has fallen by about 8%, contributing to an easing in financial conditions that’s helped spur growth. Dudley has repeatedly argued that strengthens the case for pressing ahead with rate increases to keep the economy in balance.
Policy makers have penciled in one more rate hike for 2017 and three more for 2018, according to the median projection in forecasts released last month.
There are dangers to the Fed’s approach. With inflation at 1.4% in August, continuing to raise rates would risk cementing expectations that price gains will stay permanently below the central bank’s 2% target.
Officials generally agree that the first line of defense against financial instability is so-called macro-prudential tools, such as changes in bank capital requirements or warnings to lenders about risky practices. Monetary policy is to be kept in reserve, only used to, in economists’ parlance, “lean against the wind” to avert imbalances when other measures haven’t worked.
With only four rate hikes in the past 22 months, the Fed is far from leaning against the wind with a tight monetary stance. Instead, as flagged by Yellen, it risks fanning excess credit creation by keeping policy easy.
Together with a taut labor market, some policy makers see that as a reason to return policy to a neutral setting that neither spurs nor inhibits economic growth. Yellen has suggested that such a stance would be consistent with a federal funds rate around 2%, above the bank’s current 1% to 1.25% target range.
“Elevated stock prices contribute to easy financial conditions and as such may accelerate the convergence of the funds rate to neutral, but won’t push the funds rate above that,” said former Fed official Roberto Perli, now a partner at consultant Cornerstone Macro LLC.
Of course, there’s no guarantee that Yellen will be around next year to gradually hike rates. Her four-year term atop the Fed expires on Feb. 3, and while President Donald Trump has said she could retain the job, he’s also looking at other candidates.
The emerging Fed strategy, though, does bear some resemblance to the approach advocated by the man that economists see as Yellen’s main rival – former Fed Governor Kevin Warsh. In a January presentation to the American Economic Association, the Hoover Institution fellow urged the central bank to stop trying to fine-tune inflation and instead focus more on developments in finance, money and credit.
Boston Fed President Eric Rosengren has been a leading voice in advocating that policy makers put more weight on asset prices. Speaking in New York last week, Rosengren said the Fed should raise rates in a “regular and gradual” way despite low inflation – to guard against risks that the economy will overheat, “raising the probability of higher asset prices” or inflation well above target.
It’s not just the hawkish central bankers who see potential financial risks ahead.
“In the last two episodes when unemployment reached very low levels, it was in fact financial imbalances that were the primary concern, rather than accelerating inflation,” Fed Governor Lael Brainard said Sept. 5.
While she’s argued that macro-prudential measures should be the first response to such dangers, she’s also acknowledged that they’re “incomplete” – a point that departing Vice-Chairman Stanley Fischer also makes.
“A major concern of mine is that the US macro-prudential toolkit is not large and not yet battle tested,” he said in a speech last week.
To be sure, policy makers aren’t warning that a crisis is imminent. Indeed, Yellen has described the overall risks to financial stability as moderate.
But just as the Fed must anticipate the ups and the downs of the economy in running monetary policy, it also must be forward-looking when it comes to dealing with potential financial imbalances.
And in that regard, “elevated asset valuation pressures today may be indicative of rising vulnerabilities tomorrow,” Fischer said in June. — Bloomberg