A reality check for the Federal Reserve

Federalreserve.gov

Article Highlights

  • BIS is correctly proclaiming that the U.S. and global financial markets have become excessively frothy

    Tweet This

  • BIS is correct in asserting that there are clear limits to what should be expected from monetary policy

    Tweet This

  • a recurrent weakness of Federal Reserve policy has been that of paying too little attention to asset price inflation

    Tweet This

One has to applaud the Bank for International Settlements (BIS), the Basel, Switzerland-based bank for the world's central banks, for providing the Federal Reserve with a reality check as to the state of U.S. and global financial markets. More important still, one has to salute the BIS for not pulling punches in reminding the Fed as to the potentially high cost of an overly easy monetary policy, especially if it is maintained for too long. Hopefully, this time around, the Fed will take to heart the BIS's cautionary advice, unlike the case with similar BIS advice in the immediate run-up to the 2008-2009 U.S. housing and financial market bust.

At a time when Federal Reserve Chair Janet Yellen is still managing to convince herself that U.S. equity market valuations are within their normal historical ranges and that it is not yet time to worry about overextended credit markets, in its recently released annual report, the BIS is correctly proclaiming that the U.S. and global financial markets have become excessively frothy. It does so by pointing to the basic disconnect between the financial markets' current buoyancy and the relatively lackluster U.S. and global economic performance. To back up that claim, the BIS observes that market participants are pricing in hardly any risk at all as is underlined by the fact that volatility in equity, fixed income and foreign exchange markets have all sagged to historic lows. Meanwhile, credit spreads have narrowed to very low levels as investors have stretched for yield in a very low interest rate environment.

Perhaps the most valuable criticism that the BIS levels at U.S. monetary policy making is that the Fed's policy timeframe remains too short and that the Fed continues to pay too little attention to asset and credit market inflation. This leads the Fed to have a two-year policy framework focusing too much on the shorter-lived economic cycle and too little on the longer-lived financial market cycle. That inattention gives rise to periodic asset price booms and busts that can be costly, as was certainly the case with the 2008-2009 housing and credit market bust. It also causes the Fed to be too quick in responding to the first sign of an economic downturn with monetary policy stimulus and to be too slow in withdrawing monetary policy stimulus in an upturn.

As to current U.S. economy policy challenges, the BIS is correct in asserting that there are clear limits to what should be expected from monetary policy. This is especially the case once interest rates have already been reduced to exceptionally low levels and once quantitative easing policies have already buoyed equity and credit market prices to artificially high levels. In that setting, it is crucial that monetary policy is supported by more structural reform-type policy measures aimed at improving bank balance sheets, dealing with the debt overhang problem and increasing economic productivity.

Over the past 15 years, a recurrent weakness of Federal Reserve policy has been that of paying too little attention to asset price inflation. Hopefully, the BIS's candid and well-reasoned criticism will shift the Fed away from its habitual tendency to focus almost exclusively on the immediate term and to underestimate the cost of asset price booms and busts. If the Fed does not do so, we should brace ourselves for yet another painful asset and credit market bust once the process of interest rate normalization eventually begins.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Desmond
Lachman

What's new on AEI

AEI Election Watch 2014: What will happen and why it matters
image A nation divided by marriage
image Teaching reform
image Socialist party pushing $20 minimum wage defends $13-an-hour job listing
AEI on Facebook
Events Calendar
  • 27
    MON
  • 28
    TUE
  • 29
    WED
  • 30
    THU
  • 31
    FRI
Monday, October 27, 2014 | 10:00 a.m. – 11:30 a.m.
State income taxes and the Supreme Court: Maryland Comptroller v. Wynne

Please join AEI for a panel discussion exploring these and other questions about this crucial case.

Tuesday, October 28, 2014 | 9:30 a.m. – 12:15 p.m.
For richer, for poorer: How family structures economic success in America

Join Lerman, Wilcox, and a group of distinguished scholars and commentators for the release of Lerman and Wilcox’s report, which examines the relationships among and policy implications of marriage, family structure, and economic success in America.

Tuesday, October 28, 2014 | 5:30 p.m. – 7:00 p.m.
The 7 deadly virtues: 18 conservative writers on why the virtuous life is funny as hell

Please join AEI for a book forum moderated by Last and featuring five of these leading conservative voices. By the time the forum is over, attendees may be on their way to discovering an entirely different — and better — moral universe.

Thursday, October 30, 2014 | 2:00 p.m. – 3:00 p.m.
A nuclear deal with Iran? Weighing the possibilities

Join us, as experts discuss their predictions for whether the United States will strike a nuclear deal with Iran ahead of the November 24 deadline, and the repercussions of the possible outcomes.

Thursday, October 30, 2014 | 5:00 p.m. – 6:15 p.m.
The forgotten depression — 1921: The crash that cured itself

Please join Author James Grant and AEI senior economists for a discussion about Grant's book, "The Forgotten Depression: 1921: The Crash That Cured Itself" (Simon & Schuster, 2014).

No events scheduled today.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.