The Fed’s Bully Pulpit on Wall Street
|July 18th, 2014, 09:58 PM||#1 (permalink)|
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The Fed’s Bully Pulpit on Wall Street
WASHINGTON — EIGHTEEN years ago, when Alan Greenspan wanted to send a message that he was worried that the stock market was getting a little bubbly, he did it with a typically inscrutable phrasing buried in an otherwise unremarkable speech.
In 1996, Mr. Greenspan, the Federal Reserve chairman, mused about how the Fed would know “when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions.” The next morning the stock market sold off ferociously on the mere hint of his concern.
How things change.
Mr. Greenspan’s comments were vague and subject to varying interpretation, and even then they prompted hand-wringing over whether it made sense for the nation’s top economist to tell the financial markets that prices might have risen too high. Contrast Mr. Greenspan’s comments with those Tuesday and Wednesday by the woman who now holds that same job. Janet L. Yellen deployed the bully pulpit of the Federal Reserve leadership to send a message on market prices.
Ms. Yellen specifically called out the valuations of leveraged loans (which fund corporate buyouts) and high-yield “junk” bonds (which fund companies viewed as having risky finances) as potentially excessive. She acknowledged that prices for a wide range of assets, including stocks, bonds and real estate, had risen, but argued that they “remain generally in line with historic norms.”
A written report accompanying Ms. Yellen’s testimony went further, pointing to “substantially stretched” valuations of social media and biotechnology stocks. An index of social media stock prices fell.
These events raise interesting questions: Should government officials speak up when they think markets have gotten prices wrong? At what point does the Fed leader go from being the nation’s economist in chief to the market strategist in chief? And should investors listen to Ms. Yellen’s views?
Here is the predicament that Ms. Yellen and other top policy makers face. The last two recessions in the United States have been caused by the popping of asset bubbles, first the stock market in 2000, then housing in 2007.
The mission Congress assigned the Fed is to look after the real economy — maximum employment and stable prices, to be precise. But all of their policy tools work through the financial system. They are trying to maintain low unemployment and low inflation, but they do that almost exclusively by buying and selling bonds.
That means that their policies often have a more significant impact (and certainly a more immediate and measurable one) on the price of, say, junk bonds than they do on job creation and wages.
That is always true, but it has never been more true than lately, with the Fed deeply engaged in unconventional steps to try to increase economic growth, leading to nearly $4.5 trillion in assets ending up on the central bank’s balance sheet.
To some degree, the whole point of that exercise was to drive up the prices of stocks and other assets to encourage economic growth. But a major risk all along has been that the efforts would raise asset values to bubble territory without accompanying economic growth.
If you believe that is happening, there are two options. One, embodied in a speech at the University of Southern California on Wednesday by the president of the Dallas Fed, Richard W. Fisher, is to pull back on money printing. But if you believe that the Fed needs to keep doing everything it possibly can to get stronger growth, then you are left with a few other options. One, which Ms. Yellen has repeatedly emphasized, is regulating banks and other financial institutions well to ensure that even if a bubble does emerge, and pop, the rest of the economy does not go down with it. There is no reason that somebody paying too much for junk bonds or social media stocks now needs to cause a recession in 2016, in other words.
Another option is to use “open mouth policy” (as opposed to the usual “open market policy”), jawboning markets to try to rein in excesses that might create risks. It is not an outlandish idea. The economist Dean Baker has argued that if Mr. Greenspan had made full-throated, public arguments that there was a housing bubble in 2004 and 2005, it might have led to fewer people stretching to buy homes and less damage when the bubble eventually popped.
But it does amount to a government official substituting her own judgment for that of the marketplace, the prices arrived at by thousands of buyers and sellers for an app maker or a leveraged loan.
For a sense of the risks there, consider this: Mr. Greenspan’s warning of irrational exuberance in the stock market was in December 1996. The worst excesses of the dot-com bubble occurred years later; even at the low point of the post-dot-com stock crash and the financial crisis of 2008, prices never again fell that far. A person who ignored Mr. Greenspan’s advice and bought into the Standard & Poor’s 500-stock index the morning after his speech has earned a 268 percent return since then (including reinvested dividends).
As Ms. Yellen may learn, the challenge of telling people when the prices are right is that you might just be wrong.