The Federal Reserve's policy dilemma

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Article Highlights

  • US year-to-date growth is only 0.95 percent, hardly cause for excitement.

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  • Fed should not abruptly tighten policy, which may cause an asset bubble to burst.

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  • Fed must proceed with caution regarding future policy.

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Key points:

  • It is too soon to get excited about the US economy’s second-quarter growth rate of 4 percent; when averaged with the first quarter, year-to-date growth is only a sluggish 0.95 percent.
  • The Federal Reserve should not respond to this perceived rebound with quick monetary tightening, which could encourage the bursting of an asset bubble and an ensuing collapse of liquidity.
  • The Fed should proceed with caution when considering how to exit its current accommodative policy, looking at factors such as the average pace of growth rather than just snapshot numbers.

 

The celebration of the US economy’s second-quarter growth “rebound” to 4 percent will be short. The headline number’s strength exaggerates the growth pace. It would be dangerous if this number speeds up Federal Reserve tightening, as some Federal Open Market Committee (FOMC) members have suggested. Philadelphia Federal Reserve President Charles Plosser underscored the pressure on the FOMC for tighter Fed policy by dissenting from the July 30 FOMC statement’s call for a continued “considerable period” of accommodation.1

Markets may already have reflected an expectation of higher growth. The Standard & Poor’s (S&P) 500 Index stood at 1,970 on July 30, the day the 4 percent growth number was released. It fell as low as 1,910 by August 7 and has since recovered only to about 1,950.

The modest rebound in the S&P 500 has been helped by falling interest rates that are signaling weaker growth and suggesting to some in the markets that the Fed may delay tightening further. Since July 30, the yield on five-year notes has dropped from 1.76 percent back down to about 1.59 percent in mid-August, a large move by historical standards. That drop in intermediate and short-term interest rates is reflecting lower expectations about the duration and extent of Fed tightening (figure 1).

Figure 1. Five-Year Treasury Constant Maturity Rate


Source: Data from Board of Governors of the Federal Reserve System.

Substantial evidence suggests that, while asset markets have responded positively to the Fed’s pledge to hold interest rates lower for a “considerable period,” the good news is largely over without further Fed accommodation. The S&P 500 has reached 210 percent of its June 2009 trough level in this expansion, well above the roughly 150 percent level that would have appeared in the typical post–World War II expansion (figure 2). Stocks have already priced the Fed’s efforts to boost risky assets, as the Shiller PE ratio, a modified measure of the S&P price-to-earnings ratio, underscores. That ratio has risen to over 25, potential bubble territory and well-above the historical average of just above 16 (figure 3).

Figure 2. S&P 500 Monthly Closing Price (Normalized to 100)


Source: Data from Yahoo! Finance.

Figure 3. Shiller Price-to-Earnings Ratio for the S&P 500


Note: Price-to-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years.
Source: Data from Robert Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000).


Without more artificial stimulus from the Fed that would only further inflate what may already be an asset bubble, stock prices may—appropriately—begin to fall. One hopes the drop occurs at a modest pace, but the risk of a bubble collapse is real.

Growth Remains Weak

How robust is US growth? It is best to average two choppy quarters, especially when the first quarter was depressed—now to a −2.1 percent pace—by special factors such as severe winter weather and inventory growth at the end of 2013. The average growth rate of the first half of 2014 was 0.95 percent, a lot weaker than the 3 percent pace the Fed and most analysts expected early in the year and actually pretty close to stall speed.
Inventory changes, or changes in the stock of unsold goods, exaggerated the volatility of first-half growth numbers, accounting for nearly half (1.7 percentage points) of the second-quarter growth “rebound.” Final sales, the best measure of demand growth, rose at a modest 2.3 percent pace after having fallen at a 1 percent pace during the first quarter. Those figures put the average pace of US demand growth during the first half of 2014 at 0.65 percent. We need four times that pace to sustain a recovery, especially when the Fed is tapering and talking about raising interest rates next year—as if to declare its confidence in an as-yet-nonexistent, sustainable recovery.

Despite the temporary distraction of misleading headline growth numbers, the biggest question facing investors, producers, and households in today’s low-volatility, yet largely trendless, global economy is this: Will we witness the bursting of the “mother-of-all-bubbles,” creating global economic chaos, as the Bank for International Settlements (BIS) suggests in its June annual report?2 Or will the current Janet Yellen Federal Reserve path of holding the federal funds rate at zero for a “considerable period” after the asset purchase program ends enable the Fed to successfully exit its extraordinarily easy monetary policy?

Bubbles Are Dangerous

It is important to approach this question with humility. At the least, deciding between the stances of Yellen and the BIS on correct policy now, almost six years after the Lehman bubble, requires understanding what happens in markets when a bubble bursts.

The main result of a bursting financial bubble and attendant falling prices of financial assets is a surge in the demand for cash (liquidity) among households, producers, and financial institutions, many of which are experiencing runs on their deposits. Cash means unconditional liquidity, which is always quite scarce but virtually unobtainable after a bubble has burst. In monetarist terms, where the growth of money plus the growth of velocity (the rate at which money is changing hands) equals the growth of nominal GDP, velocity collapses as less-liquid assets are dumped to raise cash. The result is the equivalent of a collapse in the money supply just as the money supply is being cut by a surge in disintermediation as depositors flee banks.

Therefore, a bursting bubble and the ensuing collapse of liquidity create an unstable, self-reinforcing downward spiral in asset prices and economic activity. Absent aggressive money printing by the central bank, financial panic ensues. The US faced financial panic after the September 2008 collapse of Lehman Brothers. The Fed responded by printing money, and by March 2009, financial markets began a strong recovery. The real economy would not have achieved sustained growth absent large doses of fiscal and monetary stimulus.

Now, six years after the Lehman collapse, the fiscal stimulus has been over for nearly two years. Monetary stimulus is being reduced by way of a tapering of Fed asset purchases, and the Fed is signaling that the federal funds rate will start to rise in a year or so.

No Easy Exit

Yellen is betting that growth will rebound before a rise in inflation forces the Fed to tighten to cut the inflationary excess supply of cash. Lacking evidence of inflation, the BIS view is that too much cash has already boosted prices of risky assets so high that if fighting inflation forces the Fed to tighten, asset markets will collapse as the demand for cash resurges. The Fed, in this scenario, will be seen to have created a bubble that bursts once a predictable rise in inflation forces it to tighten.

Alternatively, the Fed, facing a collapse of asset prices, may delay tightening even in the face of rising inflation. The result would be a rise in inflation expectations accompanied by a further surge in the demand for risky assets and for goods and services. The economy would boom for a time, but the bubble would grow even larger, only to create even more chaos once the Fed is forced to tighten to avoid a potential inflation spiral.

How, then, should the Fed proceed? First, it should admit that it still does not know how to exit the extreme monetary accommodation required to avoid a financial and economic collapse after a crisis like the one that hit the US financial market in September 2008.

Second, the most formidable exit problem lies with timing and pace. Yellen critics say that the time to have begun exiting has already passed, but persistent subtrend growth and subtarget inflation raises serious questions.

Third, the Yellen approach obeys a basic rule of policy. When you do not know what will follow from an attempt to employ monetary policy to deflate a bubble, proceed with extreme caution until rising inflation forces your hand. BIS’s suggestion that asset prices are too high and may lead to an even larger future bubble is not without merit, but an abrupt Fed move toward more tightening risks a sharp drop in asset prices, creating even more instability than during the May 2013 “taper tantrum.”

Going forward, humility and caution are crucial. A Schumpeterian “cold shower” market-cleansing could just be too risky, especially given that US demand (final sales) growth averaged a very weak 0.65 percent during the first half of 2014. Based on what we know from the Great Depression, the pain for a weak economy from an abrupt cold shower could exceed that from an overextended warm bath of monetary accommodation.

This paper is adapted from an article by the author that was originally published by Real Clear Markets on August 7, 2014.

Notes
1. Board of Governors of the Federal Reserve System, “2014 Monetary Policy Releases,” July 30, 2014, www.federalreserve.gov/newsevents/press/monetary/20140730a.htm.
2. Bank of International Settlements, 84th BIS Annual Report, 2013/2014, June 29, 2014, www.bis.org/publ/arpdf/ar2014e.htm.

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