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

In year four of Dodd-Frank, over-regulation is getting old
image Halbig v. Burwell: A stunning rebuke of a lawless and reckless administration
image Beware all the retirement 'crisis' reports
image Cut people or change how they're paid
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Monday, July 21, 2014 | 9:15 a.m. – 11:30 a.m.
Closing the gaps in health outcomes: Alternative paths forward

Please join us for a broader exploration of targeted interventions that provide real promise for reducing health disparities, limiting or delaying the onset of chronic health conditions, and improving the performance of the US health care system.

Monday, July 21, 2014 | 4:00 p.m. – 5:30 p.m.
Comprehending comprehensive universities

Join us for a panel discussion that seeks to comprehend the comprehensives and to determine the role these schools play in the nation’s college completion agenda.

Tuesday, July 22, 2014 | 8:50 a.m. – 12:00 p.m.
Who governs the Internet? A conversation on securing the multistakeholder process

Please join AEI’s Center for Internet, Communications, and Technology Policy for a conference to address key steps we can take, as members of the global community, to maintain a free Internet.

Thursday, July 24, 2014 | 9:00 a.m. – 10:00 a.m.
Expanding opportunity in America: A conversation with House Budget Committee Chairman Paul Ryan

Please join us as House Budget Committee Chairman Paul Ryan (R-WI) unveils a new set of policy reforms aimed at reducing poverty and increasing upward mobility throughout America.

Event Registration is Closed
Thursday, July 24, 2014 | 6:00 p.m. – 7:15 p.m.
Is it time to end the Export-Import Bank?

We welcome you to join us at AEI as POLITICO’s Ben White moderates a lively debate between Tim Carney, one of the bank’s fiercest critics, and Tony Fratto, one of the agency’s staunchest defenders.

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