The Fed Increasingly Resembles Mexico's Central Bank
Rudi Dornbusch, the late renowned MIT professor, once famously said of the Mexican Central Bank that he could understand it having made mistakes. After all, its board members were only human. However, what he could not understand was how the same people could have made the same mistakes time after time.
On considering the global asset bubbles that the Federal Reserve has been inflating over the past 18 months by its unprecedented balance sheet expansion, one has to wonder whether the same might not be said of the Fed as was said of the Mexican Central Bank. Since this now has to have been the third time in the past 15 years that the Fed has blown asset price bubbles through its excessively easy monetary policy stance. And seemingly the Fed learns nothing from the subsequent bursting of these bubbles. Rather, despite increased signs of global market frothiness, it continues to expand the size of its bloated balance sheet, which now exceeds a staggering $ 4 ¼ trillion.
The recently released Annual Report from the Bank for International Settlements (BIS), the Basel-based bank of the world's central banks, provides a slew of data supporting the view that excessively buoyant global financial markets have become largely disconnected from the rather lackluster global economic performance of recent years. Despite the most mediocre of economic recoveries, global equity markets have skyrocketed to new record highs and volatility indices have sunk to all-time lows. Meanwhile, global credit markets too have reduced interest rates for risky borrowers both in the corporate high-yield market and in the European economic periphery spaces to levels that almost certainly do not price in historic probabilities of default.
A further indication that global markets might have become disconnected from underlying economic and political fundamentals is that they appear to have been largely unfazed by a confluence of increased global risks. In particular, it is striking how markets have shrugged off the tectonic changes now taking place in the oil-rich Middle-East's political landscape with the resurgence of Islamic fundamentalism. It is also striking how markets have minimized the geopolitical risks associated with the Ukraine crisis and how they have downplayed the likelihood of any renewed intensification of the European sovereign debt crisis at the very time that the European economic recovery sputters and Europe's deflation risk rises.
Fed Chair Janet Yellen's repeated denials that US and global equity and credit markets might be overly frothy would seem to underline the point that the Fed keeps making the same mistake of first denying and then underestimating the cost of asset price inflation. It does so by basically restricting its policy focus to unemployment and goods price inflation to the exclusion of asset price inflation. The Fed did so first with the technology bubble at the start of the 2000s and then again with the housing and credit market bubble in the mid-2000s. Currently it seems to be doing so yet again with the global equity and credit market bubbles.
In a manner reminiscent of former Fed Chairman Alan Greenspan in the run up to the bursting of the US housing and credit market bubble in 2007, Ms. Yellen subscribes to the view that it is not the role of policymakers to identify much less to pop bubbles in the early stages of their formation. Rather, in her view, what policymakers should do is to carefully regulate the banks through leverage requirements or loan-to-value requirements to ensure that the financial system is resilient enough to withstand the bursting of bubbles should that actually occur.
A problem with Ms. Yellen's approach is that rather than using interest rate policy as a means to remove the proverbial punchbowl before the financial market party really gets going, her forward guidance that interest rates will be kept low for a protracted period of time and will not be used to deflate bubbles gives the markets a green light to keep on partying. This raises the real risk that the asset price bubbles across global credit and equity markets -- which she herself grudgingly now acknowledges might be forming - could become all the more pronounced. It also raises the risk that once again the Fed might be underestimating the impact of the bursting of these bubbles. Especially if it affects the parts of the financial system that are beyond the Fed's regulatory reach.
Only time will tell whether the BIS is right in sounding the alarm again, as it did prior to the bursting of the US housing bubble, or whether Ms. Yellen is right in being as sanguine as she appears to be today about global financial market risks. Sadly, however, the clues all seem to be pointing in the direction of the BIS being right in its concern about the current frothiness of US and global asset markets. This suggests that we should brace ourselves for yet another rough ride in global financial markets when interest rates eventually start to be normalized.
