Shades of Irrational Exuberance
There are a few days in life when you know, just know, that what is transpiring that day will be permanently etched in your memory forever. You know you will remember exactly how the day unfolded, where you were, what you were wearing, what you were thinking, what you said, to whom you said it, and the emotions that engulfed you.
Fortunately, I suppose, there are not too many days like that in most of our lives. And hopefully, most are days of joy, special days involving our loved ones.
But life also involves our professional sojourns, and here, too, there are special days. I’ve been a Fedwatcher for almost a quarter century, and there are eight days I remember vividly, as if they were recorded on a DVD in my brain, knowing that what the Fed did and/or said would have long-lasting implications, most notably for asset prices. And with a lag, of course, the economy itself.
For, you see, monetary policy works by inciting changes in financial asset prices, which in turn change the calculus of decision makers in the tangible asset world, sometimes known as the real world.
The Fed’s ultimate objectives – full employment and price stability – are connected to the real world, but the Fed cannot target changes in the real world directly. The Fed can only directly and indirectly target changes in the financial world, through (1) changes in its Fed funds rate instrument, and even more important, (2) talk about prospective changes in its Fed funds rate instrument.
This really is what the Fed does: it pegs the Fed funds rate, which is the rate of return on overnight money – which always trades at par! – and thereby indirectly targets an array of asset prices – sometimes known as “financial market conditions” – in an attempt to elicit outcomes consistent with its ultimate goals for the real economy.
It is often said that the Fed doesn’t do this, that it doesn’t really target asset prices, only the real economy. And technically, that is rhetorically correct, just as it’s rhetorically correct to say my physician doesn’t target my cholesterol level, just the good health of my heart.
But Doctor John (Laura, an awesome dude!) can’t get directly at my heart, while he can get directly – or at least try to! – at my diet. When he briefs me after my annual physical in a few weeks, my keenest interest, I confess, will be in whether he blesses me going back to eating macaroni and cheese. It’s my absolute favourite food, which he took away from me last year (because I was north of 200 on that dreaded cholesterol metric!).
Yes, Doctor John has only my best interests at heart, notably the health of my heart. But he pursues those best interests by either punishing me or rewarding me. Damn him; and bless him!
And the Fed operates in the same fashion regarding the economy’s health, using both deed and word regarding the Fed funds rate to influence the setting of asset prices, which most fundamentally are founded on (1) the opportunity cost of cash and (2) an amalgamation of risk premiums, including a risk premium for uncertainty.
Put less technically, the Fed prescribes and proscribes liquidity conditions, punishing financial markets when we are providing too much stimulus to the real economy and rewarding financial markets when we are providing too little stimulus – or, heaven forbid! – too much restraint on the real economy.
But, just as the case with me and Doctor John, the Fed and the financial markets don’t always see eyeball to eyeball about what is, or isn’t, just the right amount of stimulus or restraint. To wit, there is often a slip between the Fed’s cup and the financial markets’ lip and, in turn, the real economy’s lip.
When such slips reach critical mass, they produce the magical days that I will remember for the rest of my life: the Fed declaring, in act and/or deed, that it is changing the contours of the cup. Last Tuesday was just such a day.
Day Number Eight
As everybody, including the shoeshine professional at the airport now knows, minutes released last Tuesday of the December 14, 2004 FOMC meeting were more “hawkish” than expected, leading the asset markets to anticipate – “price in,” as we say on Wall Street – a higher trajectory for Fed funds than previously expected.
This, in itself, was no big deal. The FOMC quite regularly nudges market expectations – as to the economic outlook as well as its own reaction function – a touch one way or the other.
Accordingly, the “biggie” paragraph from the minutes quoted in every media outlet in recent days was not the reason I will remember last Tuesday for the rest of my career. Just for the record, here’s that paragraph (my emphasis in all quotes hereafter):
“The Committee’s discussion of policy for the intermeeting period, all of the members (the members of the Board of Governors and the five voting Reserve Bank Presidents) favoured raising the target for the federal funds rate by 25 basis points to 2¼ percent at this meeting. All members judged that a further quarter-point tightening in the target federal funds rate at this meeting was appropriate in light of the prospects for solid growth and diminished slack. Even with this action, the current level of the real funds rate target remained below the level it most likely would need to reach to keep inflation stable and output at its potential. With the economic expansion more firmly entrenched, cost and price pressures were likely to become a clearer intermediate-term risk to sustained good economic performance absent further reduction of accommodation.”
The bottom line of that paragraph is simply that the FOMC, collectively, believes that the prevailing real Fed funds rate target1 at 0.75% is too low for its visceral macroeconomic taste (2.25% nominal Fed funds minus trailing 1.5% year-over-year change in the core PCE deflator = .75% real Fed funds).
It ain’t too low for my tastes, as I’ve been preaching for a long, long time.2 But I’ve always known that the FOMC consensus was well above me on the notion of the “neutral” real Fed funds rate, so no surprise here in the minutes.
Indeed, the FOMC had declared in its (ridiculously short and formulaic!) statement after the meeting on December 14 that despite its tightening that day to 2.25% for the nominal Fed funds rate, policy was still “accommodative”.
Accordingly, the related paragraph in the minutes of that meeting was akin to an announcement that the sun came up in the east this morning. It did. I saw it, but it wasn’t particularly memorable, ‘cause Morgan le Fay3 and I knew it would be coming up from that direction.
Rather, our near-spiritual reaction to the minutes came from two other paragraphs, separately and even more soulfully, together: on global imbalances and excessive risk-taking in financial markets.
First on global imbalances:
“A number of participants voiced concerns about domestic and global financial imbalances. On the domestic front, such concerns focused on the magnitude of current and projected fiscal deficits, which seemed likely to keep national saving low. Views about the prospects for fiscal restraint in the years ahead were mixed; some participants believed that the odds of significant deficit reduction over the next few years were remote while others were more optimistic. Regarding global imbalances and the current account deficit in the United States, a number of participants expressed doubts that such imbalances would be reduced in the near-term. Better global balance would require not only greater national saving in the United States but also a notable strengthening in domestic demand among major trading partners. Such a strengthening seemed unlikely in the near term given the recent softening in the economies of several important industrial countries.”
Next, on excess risk-taking, the FOMC said:
“In their discussion of financial market conditions, participants noted that investors anticipated further increases in the federal funds rate over the coming year, but intermediate- and long-term interest rates along with financial conditions more generally had remained quite supportive of growth. A few participants commented that the generally low level of interest rates across a wide range of maturities and the recent flattening of the slope of the yield curve (measured as the spread between ten- and two-year Treasury yields) might signal that expectations of longer-term growth had been marked down.
Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums.”
Theory Meets Shades of Irrational Exuberance
These two paragraphs, together, are the FOMC’s first “official” recognition of the inherent contradiction between:
· Its objective to pursue full employment in the United States in the context of inadequate aggregate demand outside the United States, and
· Its objective to promote financial market stability – to wit, non-bubble “financial market conditions” – and, more generally, its objectives as custodian of the global reserve currency, to promote non-bubble global financial market conditions, including most importantly their anchor: “spread markets” in the US of A.
In examining the FOMC’s dilemma, let’s start with the simple observation that in real time, monetary policy can only influence the demand side of the economy, not the supply side of the economy. Put more technically, the supply side of the economy is more or less fixed in real time, so what the Fed can do is influence demand versus that relatively fixed supply, generating changes in resource utilization and thereby, inducing changes in inflation.
Yep, this is how Fed policy works: it’s a Keynesian, Phillips Curve world!
Thus, if employment is less than full employment (a disinflationary influence on wages), the Fed is duty bound to stimulate aggregate demand growth greater than sustainable aggregate supply growth, generating demand for underutilized labour resources. Macroeconomics 101 stuff, here, really; pretty simple stuff.
The dilemma comes in Macroeconomics 102, where we learn that U.S. aggregate demand is more import elastic than is non-U.S. global aggregate demand. Thus, if the Fed seeks to indirectly stimulate job growth in America, by stimulating aggregate demand growth in America, the inevitable – tautological! – outcome will be a larger U.S. trade deficit.
Which brings us to Macroeconomics 103, where we learn that the trade deficit drives the current account deficit, which as a tautology must be financed with a capital account surplus, also known as net foreign investment into the United States.
We further learn that the capital account surplus comprises both private and official foreign net investment in America, and can be in the form of direct investment in tangible assets and investment in both equity and debt instruments.
And finally, in this class, we learn that private investors tend to make their net investment in all three forms, while official institutions tend to be almost exclusively fixed income investors.
Which brings us to Macroeconomics 104, where we learn that private foreign net investment in America is putatively a good thing, while a large share of foreign official investment flows in America’s capital surplus is ostensibly a bad thing. Why?
Foreign private investors in America are theoretically profit-maximizers and are coming to America to make profits, which is a sign that investment in America must be more profitable than in other places.
In contrast, foreign official investors in America are not profit maximizers, and are lending America money as an act of mercantilist self interest, so as to keep their own currencies undervalued, thereby giving their exporters an “unfair” advantage against American producers.
Accordingly, we also learn that the greater the official share of America’s capital account surplus, the more unsustainable it is, and therefore, the more unsustainable America’s current account (or trade) deficit is. Why?
Since foreign official investors are not profit maximizers, there is no assurance they will continue to lend America dollars if and when their non-profit motives change, generating a disorderly decline in the dollar and dollar-denominated asset prices and, therefore, a dark winter for the American economy.
Now, finally, we have the theoretical prerequisites to register for the Senior Seminar, in which we try to apply what we have learned to the real world. And the first thing we learn is that the real world is a lot messier than the textbook world!
In present circumstances, the Fed’s dilemma is either to: (1) downgrade, if not reject, its mandate to foster full employment in America, or (2) pursue that mandate with the virtual certainty of an ever-larger U.S. current account deficit, exposing America to the risk that foreign official investors suddenly decide, for their own non-profit maximizing (political?) reasons, to let a plunging dollar plunge America into a recession (depression?).
Which, of course, would result in the antithesis of the Fed’s mandate to foster full employment in America.
So far, the Fed has chosen to honour its duty to pursue full employment in America, underwriting the risk – repeat, risk! – that foreign official financing of America’s current account deficit becomes less agreeable. I firmly – very firmly! – believe the Fed has made the right choice, even as I respect others that feel differently.
I do not view foreign official investors in America as either strangers or acting out of kindness, but rather people we know who are acting in their own national interest: doing the only thing they can do to support their job creation, unless and until they discover the joys of more robust domestic demand growth.
In contrast, I’ve long worried – much more than most! – about a different risk arising from current global circumstances, in which America must party in order for the world’s party staff to find employment: the risk of asset price bubbles, which ineluctably become asset price busts.
Indeed, I’ve long believed that asset price bubbles are not just a risk, but also a virtual certainty stemming from current global circumstances.
The Fed As Bartender
In order for America to play the role of global aggregate demand partier of first and last resort, in the face of American monetary stimulus leaking out through the current account deficit into foreign job creation, American consumers need to feel good about themselves.
And nothing makes the American consumer feel as good as elevating property prices. Nothing!
House price inflation emboldens consumers to spend liberally out of current income, secure in the knowledge that the house is doing the heavy lifting of wealth building. And for the most animal-spirited of consumers, it allows them to turn their houses into ATM machines.
Accordingly, there is nothing wrong with the Fed offering happy prices for property price tippling, if and when there is a whiff of deflation in the air, borne of irrational ennui. Such was the case in 2001, when the corporate sector checked itself – with a little nudge from the PIMCOs of the world! – into the Betty Ford Center for Balance Sheet Rehabilitation, where job destruction is the order of the day.4
In the wake of that end-of-corporate-denial moment, the American consumer needed some lift to his and her git-along. Job creation wasn’t going to do it. And the Fed provided that lift.
Indeed, on these pages in July 2001,5 I wrote approvingly, declaring that:
“The average American also owns a home. In fact, the home ownership rate in America is at a record high 68%. And while most of those homes are levered, there is room to lever them even more, from both a balance sheet and an income statement perspective. Most important, perhaps, valuation of homes – the price of a home divided by the shelter services that it provides – is secularly cheap.
There is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing (just like he denied belatedly attacking the NASDAQ bubble). So, while I may think Washington needs to put more Keynesian proof in the policy beverage it is serving, there is no question that Washington is pouring from the right decanter.”
Whether or not the Fed has, three and one-half years later, created a bubble in house prices is an open question. At the national level, I think not, as demonstrated by the valuation metric I used back in July 2001, updated on today’s cover.
That said, many regional markets look awfully frothy to me, including the very community in which I live, Newport Beach, California. Far more important than my views, however, the FOMC is now citing property price inflation as a cause of concern!
The last time that Chairman Greenspan allowed publicly that he was concerned about asset price inflation was December 1996, when he rhetorically asked how he (and his colleagues) would know if and when equity valuations had become irrationally exuberant.
As the 1990s drew to a close, with a roaring stock market in his face, he answered his rhetorical question by saying that he could not know if equity valuations were irrationally exuberant, and that bubbles could be identified only after having proven their existence by blowing up.
He further argued that he was not tightening policy to prick an equity bubble, but merely to thwart an unsustainable wealth effect on aggregate demand. I never believed Mr. Greenspan’s Mr. Magoo act, and said so publicly, including testimony before Congress.6
I agreed with Mr. Greenspan’s instinct that the equity market was in a bubble, even as he denied that was his instinct. But it was not a generalized bubble, I argued, but rather a bubble in technology stocks, commonly known as New Economy stocks. Indeed, valuations on Old Economy stocks were getting pummeled.
Accordingly, my quarrel with him was that hikes in the Fed funds rate until tech stocks cried uncle was equivalent to “trying to get the attention of gluttons by starving anorexics. It’s bad macroeconomic policy, and it’s also morally wrong.”
I haven’t changed my mind about that. And neither has Mr. Greenspan. But now, in his last year in a great run as chairman since 1987, Mr. Greenspan again puts down a marker: he sees “excessive risk taking.”
To be sure, the minutes did not actually say that Mr. Greenspan sees excessive risk taking, but rather that “some participants” on the FOMC had that concern.
But I think it is safe to say that if Mr. Greenspan didn’t see it, the fact that other FOMC members saw it would not have been recorded in the minutes. Mr. Greenspan lives by words. And if my words here are wrong, I invite him to correct me (as he has time and time again – not in name, but in in-the-face footnotes to his speeches – regarding my advocacy of a hike in margin requirements during the equity market bubble).
Be that as it may, the December 14th FOMC minutes were the stuff of history: the FOMC openly pondering not just goods and services inflation but asset price inflation (risk premium deflation).
And truth be told, I have a lot of sympathy for the FOMC’s concern: the Fed is handicapped by what my colleague Mohamed El-Erian calls “the insufficiency of active policy instruments.” In this context, Mohamed means fiscal policy: if only the Fed could compel the fiscal authority to apply restraint on aggregate demand, the dilemma of “needing” foreign savings would be diminished.
He’s right!
Dealing With the Rowdy Drunk
For me, however, an even more binding insufficiency of policy instruments is the unwillingness of the Fed to use a regulatory tool to curtail the supply of credit to investors engaged in excessive risk taking, otherwise known as speculators.
Yes, the time has come once again to consider why the Fed refuses to do anything about “excessive risk taking” except to threaten a more nasty upward trajectory for the Fed funds rate! Regrettably, there is no rational reason to expect the Fed to see things in another way, at least under Alan Greenspan.
In contrast, Fed Governor Bernanke, in his very first speech7 as governor in October 2002, explicitly embraced the validity of using the microeconomic tools of regulation, rather than the macroeconomic tool of the Fed funds rate, in the event of suspected bubble tendencies in select markets.
Specifically, Mr. Bernanke said:
“Another possible indicator of bubbles cited by some authors is the rapid growth of credit, particularly bank credit (Borio and Lowe, 2002). Some of the observed correlation may reflect simply the tendency of both credit and asset prices to rise during economic booms. However, to the extent that credit expansion is indicative of bubbles, I think that empirical linkage points to a better policy approach than attempts at bubble-popping by the central bank. During recent decades, unsustainable increases in asset prices have been associated on a number of occasions with botched financial liberalization, in both emerging-market and industrialized countries. The typical pattern is that lending institutions are given substantially expanded powers that are not matched by a commensurate increase in regulatory supervision (think of the savings and loans in the United States in the 1980s). A situation develops in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net – the classic “heads I win, tails you lose” situation.
When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly – that is, in a way that does not allow speculative misuse of the safety net – in the first place. Or failing that, to intervene and fix the problem when it is recognized.”
I could not agree with Mr. Bernanke more! The Fed should not<