(This post originally appeared at Bloomberg View.)
Asset prices, by historical measures, are high across the board. The reason seems simple: Low risk-free rates, courtesy of the Federal Reserve, are driving investors out of cash and into risk assets. To many, the implication is clear: The Fed needs to raise interest rates in order to prevent a destabilizing market crash.
That isn't a good idea. Let me explain why.
First of all, higher asset prices due to lower safe interest rates aren't some kind of nefarious plot -- this is just Finance 101. The value of a financial asset is the discounted present value of its future payoffs, and when the discount rate -- of which the Fed interest rate is a component -- goes down, the true fundamental value of risky assets goes up mechanically and automatically. That’s rational price appreciation, not a bubble.
OK, but what if a bubble does occur? At this point, pretty much everyone except for a small handful of aging academic economists believes that bubbles really do happen. What if the Fed’s easy policy has fed a big one?
Well, of course that can’t be ruled out, but everything we know about bubbles goes against that idea. The theory of speculation tells us that bubbles form when people think they can find some greater fool to sell to. But when practically everyone is convinced that asset prices are relatively high, like now, it’s pretty obvious that there aren’t many greater fools out there.
If you look at past bubbles, such as the late-'90s tech bubble or the mid-2000s housing bubble, you see that there was always a large contingent of society that thought it wasn’t a bubble at all -- that “this time, it’s different.” Who nowadays thinks that there’s some special Big New Thing that’s going to push stocks and bonds and commodities all to stratospheric heights forever? Who has a story for why recent asset price rises should be followed by even more asset price rises, and then even more? No one I know of. Paradoxically, the one time it’s hardest to have a bubble is when everyone and their dog is unhappy about asset prices and scared that there’s a bubble.
Actually, there’s laboratory evidence for bubbles, too -- it’s by far the most-researched phenomenon in experimental finance. And it’s true that when you give traders in the lab more cash, you get more and bigger bubbles. Unfortunately, it’s also the case that raising interest rates doesn’t pop the bubbles, which tend to form whenever some people don’t understand fundamentals.
Conclusion: The Fed has raised asset prices, but there’s no sign that it has caused an irrational rise in prices.
Basically, the people calling for Fed Chief Janet Yellen and the Fed to raise rates are demanding that the Fed crash asset prices in order to avoid an asset price crash. That may sound like a good idea if your mental model is a little pain now to prevent a lot of pain later. But if the rise in prices has been a rational response to Fed easing, then there’s no need for such medicine; causing a crash today will just cause a crash today, period.
There is also the idea that the rise in asset prices is simply unnatural or artificial. But the Fed has been regulating the monetary base for many decades, and for a lot of that time there were no big bubbles. Like it or not, the Fed is a natural part of the financial ecosystem, and we just happen to find ourselves in a time in which the Fed is more important than usual. Also, it seems to me that “naturalness” is a pretty weak justification for deliberate government action to crash the value of Americans’ retirement accounts.
If you talk to the people at the Fed, it’s very clear that they worry about asset bubbles -- how could they not, when they’ve been partially blamed for two big ones less than 10 years apart? But the Fed isn’t yet worried enough about bubbles to use the blunt hammer of rate hikes. Its cautious, middle-of-the-road policy seems very at odds with the extremism that a lot of people in the finance industry seem to attribute to it. I say we hold off on our calls for anti-bubble rate hikes.
The Fed needs to raise interest rates in order to prevent a destabilizing market crash.
ReplyDeleteagree...the fed has no need to. Yields are very low due to the huge demand from governments and institutions . All inflation indicators, except or food and some others, are still very low. The damage from trying to pop an alleged asset bubble is worse than letting it progress on its own.
But isn't the nature of a bubble is that it is unsustainable. If it is sustainable then it is not a bubble. The reason why you 'pop' a bubble is to prevent a greater crash. At some point the cost of 'popping' becomes unacceptable. NB The dotcom bubble and the US housing bubble were not 'popped' by a well meaning fed (or have I misremembered recent history?). The question is: Should the fed have done more to 'pop' the previous 'bubbles'?
ReplyDelete"Who nowadays thinks that there’s some special Big New Thing that’s going to push stocks and bonds and commodities all to stratospheric heights forever? Who has a story for why recent asset price rises should be followed by even more asset price rises, and then even more? No one I know of. Paradoxically, the one time it’s hardest to have a bubble is when everyone and their dog is unhappy about asset prices and scared that there’s a bubble."
ReplyDeleteIsn't this statement a different spin on the "this time its different" meme ?
No, because I don't think assets have high expected returns, and I'm not arguing that they do.
DeleteThis time is different, but not in the usual way of thinking. This is the first time the stock market has been making new all time highs on a regular basis due to the announcement of bad economic reports. The market hears about a bad report, immediately thinks that the Fed will keep pumping, and keeps climbing. Market psychology is already at a very dangerous spot. It thinks that momma (the Fed) will always be there to make things better if anything bad happens. It is therefore in a very comfortable place, fearing nothing, and expecting to be sheltered from any storm with ZIRP, and QE if necessary. This is a sign that investors are beginning to believe that the Fed will always provide enough liquidity to prevent a serious correction. This psychology needs to be changed before it reaches the ultimate conclusion that money will always be free. If and when that happens, the hyperinflation will begin, and that train is much harder to stop once it gets rolling. The market is becoming a spoiled child. It needs a few good whacks for it to sober up and appreciate reality.
DeleteZIRP and QE: two things that are unprecedented in the history of U.S. monetary policy, yet after these policies have been in place for over five years, Dr. Smith regards them as middle-of-the-road and cautious. Can anyone with a discerning mind even help but laugh? This man is eihter hoping for a job at the Fed, or brainwashed by the propaganda coming out of the Fed and Steve Liesman. I'm guessing the former.
"The value of a financial asset is the discounted present value of its future payoffs, and when the discount rate -- of which the Fed interest rate is a component..."
ReplyDeleteAre you saying that the Fed can independently control interest rates and inflation? For how long?
I mean, if the Fed is not controlling "real" interest rates, then it's not controlling asset prices. It's just reacting to whatever mysterious market processes determine real interest rates.
I mean, if the Fed is not controlling "real" interest rates, then it's not controlling asset prices. It's just reacting to whatever mysterious market processes determine real interest rates.
DeleteThat's a very good point...
But besides a rise in asset prices, do we have an underlying instigator this time, like the dot.com bubble or mortgage/housing bubble? I remember the euphoria in the run-up to 2007...it just doesn't seem to be there now. There's a lot more apprehension and anxiety right now. HS.
ReplyDeleteIf business profits rise indicating more value its price rises. If the profits do not rise but the price rises then there is a false price. It is over-valued. Buy, hold, sell recommendations are properly based on company value, not nowhere to put the money so put it in assets, as the article below the first NYT article in the link is titled.
ReplyDeleteThere is no limit to cash that can be put in a bank but the supply of assets is relatively limited so bubbles or balloons form.
Where there is no balance in the economy then the money goes to assets. It creates an over inflated balloon of assets and the cash balloon becomes rather deflated. The air has moved to the assets balloon. Eventually it will have to come back or be lost when the bubble or balloon bursts.
I think you greatly misstate the position of people calling for tightening to start. We're not saying, ramp up rates quickly and crash asset prices. We're saying start weaning the system off its dependence on overabundant liquidity now, in mid cycle, not later, when the cycle is about to turn.
ReplyDeleteYour argument simply assumes that low interest rates and high asset prices are better for everybody. The reality is net sellers win, net buyers lose, and holders merely have returns moved forward in time. That's why realized capital gains net to zero in national income. You are in fact siding with asset owners who are likely to sell soon against people who are likely to buy soon. For example you're taking the side of people nearing retirement over younger people, and you're siding with owners of developable land over people nearly ready to buy their first home.
But this isn't the question of asset holders vs asset buyers. Rising the interest rates when natural interest rate is very low or negative will crash the economy, stopping current growth and employment and even potentially erasing any recovery made so far. Until economy shows signs of returning to full employment (rise of wages equaling pre-2008 levels and core inflation rising to 2%), rising rates would be bad for the economy.
Delete(Personally, I would like to see rates low enough to run inflation 3 - 4% for a two years minimum, with slow return to 2% in the following year, to try to "supercharge" the economy, and, maybe, return a bit of lost growth during this crisis, but that will never happen, the moment inflation reaches 2.25% everybody will be in panic mode.)
This is a great demonstration of one of the most popular urban legends about economics. Essentially what you're saying is that it's more difficult for an economy to grow when it has high unemployment than with full employment. The opposite is true. As unemployment falls, for every increase in spending there's more associated inflation and thus less real growth. When we reach full employment the economy will become more fragile and sensitive to rate increases, not less. But rates will have to go up to counter inflation when it reemerges.
DeleteObviously I can't predict the future but on present course it looks to me like we'll be in recession before rates get back to even one.
"For example you're taking the side of people nearing retirement over younger people, and you're siding with owners of developable land over people nearly ready to buy their first home."
DeleteYou're completely ignoring unemployment and the weak labor market, which hurts younger people disproportionately. Wages haven't seen real gains in twenty years.
"We're saying start weaning the system off its dependence on overabundant liquidity now, in mid cycle, not later, when the cycle is about to turn."
The Fed has been reducing QE purchases. If you wean too quickly you'll get a recession.
I think Mason has it right here:
"Here’s another one for the “John Bull can stand many things, but he cannot stand two percent” files. "
http://slackwire.blogspot.com/2014/07/the-rentier-would-prefer-not-to-be.html
" In a world where liquidity is abundant, this coordination function is evidently obsolete and can no longer be a source of authority or material rewards.
More concretely: It may well be true that markets for, say, mortgage-backed securities are more likely to behave erratically when interest rates are very low. But in a world of low interest rates, what function do those markets serve? Their supposed purpose is to make it easier for people to get home loans. But in a world of very low interest rates, loans are, by definition, easy to get. Again, with abundant liquidity, stocks may get bubbly. But in a world of abundant liquidity, what problem is the existence of stock markets solving? If anyone with a calling to run a business can readily start one with a loan, why support a special group of business owners? Yes, in a world where bearing risk is cheap, specialist risk-bearers are likely to go a bit nuts. But if risk is already cheap, why are we employing all these specialists?
The problem is, the liquidity specialists don’t want to go away. From finance’s point of view, permanently low interest rates are removing their economic reason for being — which they know eventually is likely to remove their power and privileges too. So we get all these arguments that boil down to: Money must be kept scarce so that the private money-sellers can stay in business."
Keynes. General Theory. Chapter 22. Section VI
ReplyDeleteBattle of Noah's Internal Contradictions:
ReplyDelete"And it’s true that when you give traders in the lab more cash, you get more and bigger bubbles. Unfortunately, it’s also the case that raising interest rates doesn’t pop the bubbles"
vs.
"The Fed has raised asset prices, but there’s no sign that it has caused an irrational rise in prices."
I.e. the Fed gave traders more cash, creating a bubble. But it's not a bubble. And the Fed should not pop it, since it's not a bubble, and studies show that the Fed cannot pop the bubble anyway.
It's not so simple. In the lab, giving people cash and lowering interest rates have totally, totally different effects. Lowering rates doesn't spark a bubble - there's no "reach for yield".
DeleteWhy not discuss regulatory policy and use targeted regulation to bust bubbles? Housing bubble? Tighten lending standards on houses. Asset Bubble? Increase collateral requirements on loans. The whole economy does not need to tank.
ReplyDeleteTo many people, including many economists, regulatory policy is the devil incarnate. It is "unmentionable". For efficient economic management, regulatory policy should be an effectively wielded tool to complement monetary and fiscal policy. We have seen the failure that results when managers, such as Greenspan, who are hostile to regulatory policy, go through complex contortions to keep regulatory policy locked in the tool shed, and allow bubbles to inflate because monetary policy that would pop the bubble is inappropriate. Monetary policy, no matter how good, cannot overcome sufficiently bad regulatory policy. The hostility displayed toward regulations by academic and professional economists is misplaced.
It is time to restore regulatory policy to the prominent role it should have. The future of macro-policy is not ever finer Monetary policy and models, the future is creative and effective new regulatory policy that makes the monetary tools we have work better.
-jonny bakho
Um. It's a bubble if the asset managers who are buying are short-term focused and/or counting on the Fed to support borrowers through the next downturn like they did the last -- even though there's not much room left for monetary policy to give the Fed any traction. In short, the bubble crowd are worried that unsustainable future performance is included in current asset prices, because either (i) too many investors face the wrong incentives and are only worried about near-term borrower performance and/or failing with the crowd of asset managers (see Keynes) or (ii) investors think the Fed is a miracle worker that can prevent business failures from happening on a large scale.
ReplyDeleteThe bubble crowd think the only question is when do you want your delevaraging, now or after significantly more debt/imbalances have been allowed to build up.
To me, the late 90's "stock market" was not a bubble. It was a hot market due to a bunch of factors building since 1975: computerization, globalism, then finally Y2K. It was a investment "bubble" in better terms. Hardly new in capitalist history. By the late 90's, there was very little capital flowing across markets and exhaustion reached a point by mid-00's capital saw very little reason to continuing expansion, thus came the early 01 investment slump and "micro-recession".
ReplyDeleteNow, why did we have a micro-recession, when we would have had a typical recession........the credit bubble that began in 1997. As the economy boomed due to the investment surge, money started following financial products. Liquidity poured in from overseas creating immense demand by 1997 for financial products. This demand filtered into mortgage securities and other unsecured credit lines boosting consumption in the face of investment contraction. This created probably one of the most bizzare 'expansions" in US history. Boomer disinflation, weak investment, high residential investment following the credit lines, overconsumption despite weak wage growth, which was due to weak investment. It took unemployment until down to 4.8% to provide any wage growth. By the time the credit lines faltered, consumers did not have the cash themselves to pay their debt, which hurt creditors and threatened to destroy the economy.
I guess the answer is, sometimes you need to stop cycles and sometimes, just let them play out. By 2000, there was a great optimism that the business cycle had been abolished in markets. IMO, if the Fed had said in 2000, that the unsecured credit that had been boosting since 1997 needed to be constrained thus we need a "solid recession", it would have not gone over well with markets. So it goes back to unsecured credit and always unsecured credit.
IMO, when you inflation adjust current asset prices, they really have fallen quite a bit since 2007.
Most of the stock rally since 2013 is capitalists draining the "swamp" so to speak. All that excess capital swimming around in 2009 is finally being pulled back in and we are seeing it in improved job hiring and production. The government has missed it(which would not be the first time) but we see it in the market.
Here is what I don't get about this post or what Krugman, Simon Wren-Lewis et al assert about not raising rates to prick asset price bubbles. All of them make an "all or nothing" argument. My question is in what way would raising the Fed funds by 25 bps alter the unemployment / business spending dynamics? If you think that raising the Fed funds rate by 25 bps is going to crush business spending, you are basically arguing the margin of safety on new projects is razor thin. This is quite different from reality. Most companies seem to be targeting a required return that is well into the double digits for new projects/investments. I fail to see how a 25 bps change can alter the economic profit in a material way.
ReplyDeleteOn the other hand, raising the Fed funds suddenly will cause speculators to curb their bets and as asset prices correct. I am not sure how this outcome is worse than having a crash that results in big losses and probably an uptick in unemployment.
What about reversing the 1980 Carter Act on Deregulation of Money and move on from there. It seems that was the beginning of the credit boom, or at least, it made the credit boom possible. Add in everything since then that has tended to easing of credit and reverse them too. It seems that until these fundamentals are addressed then nothing will ever really change. People will still keep saying, this time its different.
ReplyDeleteI think you are underestimating the measures that the Fed is taking to stimulate growth. The Fed has more than doubled the money supply just in the past few years, an increase which amounts to more than all other years combined. This is not "middle of the road" this is massive intervention to try to resuscitate the U.S. economy during a much need correction.
ReplyDeleteMuch of this new money has made its way onto the balance sheet of financial institutions, and overseas. Once this money makes its way into the U.S. economy it will be reflected in higher prices. The U.S. is effectively exporting its debt to other countries in exchange for goods that are not produced in the U.S. This cannot continue, eventually there will be a loss in confidence in America's ability to pay its debts and a dollar crises will be imminent.
Many economists and financial commentators have pointed this out, but there remains a stubbornness to change course to a more sound monetary and fiscal policy.
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