A Federal Reserve Oblivious to Its Effect on Financial Markets
The Federal Open Market Committee last month didn’t even mention risk from persistent low rates.
By Martin Feldstein
The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of unconventional monetary policy. While chaos in the Chinese stock market may have been the triggering event, it was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished.
The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy. Beginning in November 2008 and running through October 2014, the Fed combined massive bond purchases with a commitment to keep short-term interest rates low as a way to hold down long-term interest rates. Chairman Ben Bernanke explained on several occasions that the Fed’s actions were intended to drive up asset prices, thereby increasing household wealth and consumer spending.
The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment.
But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks in equities and fixed-income securities, in commercial real estate, and in the overall quality of loans. There is no doubt that many assets are overpriced, and as the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability.
Unfortunately, the recently released minutes of December’s Federal Open Market Committee meeting made no mention of financial-industry risks caused by persistent low interest rates for years to come. There was also no suggestion that the Fed might raise interest rates more rapidly to put a damper on the reach for yield that has led to mispriced assets. Instead the FOMC stressed that the federal-funds rate will creep up very slowly and remain below its equilibrium value even after the economy has achieved full employment and the Fed’s target rate of inflation.
Fed officials say that macroprudential policies should be used to prevent financial instability.
But there are few such policies in the U.S. beyond the increased capital requirements for the commercial banks. Nothing has been done to limit the loan-to-value ratios of residential mortgages or the leverage in commercial real-estate investments. Moreover, the commercial banks supervised by the Fed represent only about one third of the total capital market. The Fed has no ability, for example, to reduce risks in the shadow banking or insurance industries.
The Dodd-Frank law imposed restrictions on bank portfolios and increased banks’ capital requirements, which have created new problems by reducing liquidity in financial markets.
When bond investors and bond mutual funds look to sell, there may be no ready buyers to prevent sharp falls in bond prices. The resulting rise in long-term interest rates could then reduce equity prices as well.
Moreover, the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly in the next two years. The December FOMC minutes show that members expect to have a negative real federal-funds interest rate until sometime in 2017, much too low for an economy already at full employment. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates.
The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next.
Fed officials also make the case that stimulating the economy by continued monetary ease is desirable as protection against a possible negative shock—such as a sharp fall in exports or in construction—that could push the economy into a new recession. That strategy involves unnecessary risks of financial instability. There are alternative tax and spending policies that could provide a safer way to maintain aggregate demand if there is a negative shock.
The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.
Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.
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