Has the Fed lost control of the market?
This question, first posed by Goldman last May, has received growing prominence in recent months, culminating with none other than Bill Dudley earlier this month, who pointed out the paradox of 5 consecutive rate hikes resulting in record easy financial conditions in his January 11, 2018 speech, one of his last as NY Fed Chair.
But if the Fed has indeed lost control of the market, that would mean that there is nothing the Fed can do until the market bubble bursts once the current melt-up finally rolls over?
That is quandary analyzed by Deutsche Bank in a recent report in which the bank observes that “an unprecedented bubble emerged during 2004-2006 when the Fed hiked rates 425bp” (as shown in the 3 charts below) and warns that “the current market environment is similar, in which monetary policy (hiking the policy rate) is likely to have a limited effect in restraining risk-taking.“
Deutsche then lays out the three possible scenarios that could – in theory – stop, and maybe even reverse, the current asset bubble which are as follows:
- Monetary policies or communications designed to increase volatility,
- Monetary policies designed to hike long-term interest rates, and strangely
- Regulations and supervisions to curb cryptocurrency trading.
And some further thoughts on these three points.
- First, Deutsche notes that former Fed Governor Jeremy Stein advocated for a monetary policy to cope with credit spreads (see excerpts below), but little headway was made in discussing policies targeting volatility (however, Chairman Powell prefers a communication style that raises uncertainty of monetary policy.
- Second, monetary policies designed to hike long-term interest rates include tapering quantitative easing, reducing the size of the central bank’s balance sheet, twist operations, and changes to yield curve control. Yet, these policies are all predicated on inflation accelerating.
- Which leaves option three: regulating cryptocurrency trading and initial coin offerings (ICOs) which however, unlike in China, will take time in developed countries.
And yes, the irony of the Fed trying to burst one bubble, that of cryptos, to keep the equity bubble going just a little bit longer, is hardly lost on anyone, although we are surprise by Deutsche Bank’s skepticism that this approach could work.
In summary, the biggest German lender comes to the gloomy conclusion that:
“…monetary policy and regulations/ oversight could, like in the last financial crisis, come too late to prevent an expansion of the asset bubble.“
In other words, in the worst case scenario – which appears to be DB’s base case – not only has the Fed lost control, but it is now too late to hope for central bank intervention and reversing, or even halting the asset bubble, which will therefore grow at an ever accelerating pace, until it finally bursts in spectacular fashion.
Here are the Jeremy Stein speech excerpts, FOMC Minutes and Gov Powell quotes referenced above, on the interplay of Volatility and Monetary Policy.
28 February 2014, FRB, “There is no general separation principle for monetary policy and financial stability. Monetary policy is fundamentally in the business of altering risk premiums such as term premiums and credit spreads. So monetary policymakers cannot wash their hands of what happens when these spreads revert sharply. If these abrupt reversions also turn out to have nontrivial economic consequences, then they are clearly of potential relevance to policymakers.”, “In the absence of a general separation principle, when one might consider addressing financial stability issues either with regulation or with monetary policy, it becomes all the more critical to get the case-by-case analysis right that is, to really dig into the microeconomic details of the presumed market failure and to ask when a regulatory intervention is comparatively more efficient than a monetary one, or vice versa” 18 June 2014, FRB, Chair, Yellen, “To the extent that low levels of volatility may induce risk-taking behavior that, for example, entails excessive buildup in leverage or maturity extension, things that can pose risks to financial stability later on, that is a concern to me and to the Committee.”
5 July 2017 released, Minutes of FOMC (held in 13-14 June), “In the assessment of a few participants, equity prices were high when judged against standard valuation measures.”, “A few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability.”
7 January 2017, FRB, Governor, Powell, “The current extended period of very low nominal rates calls for a high degree of vigilance against the buildup of risks to the stability of the financial system.”, “It would be very healthy to change the focus away from the median dots (which would not hit finally).”, “We can talk