Goldman Is Troubled By The Fed's Growing Warnings About High Asset Prices

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With both the S&P, and global stock markets, closing last week at new all time highs, it is safe to say that any and all warnings about “froth“, and perhaps a bubble in the market, as Deutsche Bank characterized it last week have been ignored. And yet, as Goldman’s economist team writes over the weekend, the recent rise in warnings about “risk levels” and asset prices by Fed officials is concerning: “Fed officials have expressed greater concern about asset prices and financial stability risk recently, a change from their more relaxed view last fall. In particular, the minutes to the June FOMC meeting highlighted concern about high equity valuations and low volatility and drew a connection between potential overheating in the real economy and financial markets.

To underscore this point, here is a recap of recent Fed warnings about asset prices, which have increased significantly since the presidential election:

Janet Yellen, July 12, 2017

So in looking at asset prices and valuations, we try not to opine on whether they are correct or not correct. But as you asked what the potential spillovers or impacts on financial stability could be of asset price revaluations — my assessment of that is that as assets prices have moved up, we have not seen a substantial increase in borrowing based on those asset price movements. We have a financial system and banking system that is well capitalized and strong and I believe it is resilient.

FOMC Minutes, July 5, 2017

…in the assessment of a few participants equity prices were high when judged against standard valuation measures…  Some participants suggested that increased risk tolerance among investors might be
contributing to elevated asset prices more broadly; 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… Several participants expressed concern that a substantial and sustained unemployment undershooting might make the economy more likely to experience financial instability or could lead to a sharp rise in inflation that would require a rapid policy tightening that, in turn, could raise the risk of an economic downturn.

Janet Yellen, June 27, 2017

Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios out to depend on long-term interest rates.

John Williams, June 27, 2017

The stock market seems to be running pretty much on fumes… so something that clearly is a risk to the U S economy, some correction there, is something that we have to be prepared for and to respond to if it does happen. The U S economy still is doing — I think on fundamentals — is doing quite well. So I’m not worried about some kind of late- ’90s, dot-corn bubble economy where a lot of the underpinnings were driven by the stock market.

Bill Dudley, June 23, 2017

Monetary policymakers need to take the evolution of financial conditions into consideration… For example. when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease – as has been the case recently – this can provide additional impetus for the decision to continue to remove monetary policy accommodation.

Stanley Fischer, June 20, 2017

House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.

Janet Yellen, June 14, 2017

We’re not targeting financial conditions. We’re trying to set a path of the federal funds rate, but taking account of those factors and others that don’t show up in a financial conditions index.

Robert Kaplan, June 30, 2017

That’s not to say these imbalances won’t build and I am concerned that they may but if you ask me today I think right now it’s manageable, but I do think if there were some correction also in the markets. that could actually be a healthy thing.

Neel Kashkari, May 17, 2017

Monetary policy should be used only as a last resort to address asset prices, because the costs to the economy of such a policy response are potentially so large.

Eric Rosengren, May 8, 2017

While I am certainly not expecting such a scenario to occur, central bankers are charged with thinking about adverse risks to the economy. So current valuations in real estate are one such risk that I will continue to watch carefully.

Jerome Powell, January 7, 2017

With inflation under control. overheating has shown up in the form of financial excess. 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.

Perhaps their concern is due to the following Citi chart which we have discussed on numerous occasions, and which shows the “incredible” correlation between global central bank balance sheet size and market returns in recent years.

Or perhaps the Fed is not worried about stock prices at all, and while the recent commentary about asset valuations is notable, what the Fed is really concerned about is the recent pick up in the unemployment rate, something which as Bank of America noted last week, “there are no episodes in which unemployment rose a bit and remained stable at its natural employment rate. Rather, a recession has always followed.

Whatever the reason for this unexpected shift in rhetoric, here are some additional summary observations from Goldman, which while pointing out that such comments by Fed members are quite unorthodox, “Fed officials do appear more concerned about financial stability risks, and this could strengthen the case somewhat for tightening in the future.”

  • Traditionally, Fed officials have thought it wisest to respond to financial variables through their forecasted impact on inflation and employment. They have taken a more skeptical view of using the funds rate to lean against stretched valuations, though they have not closed that door entirely.
  • We find that the Fed has largely followed these principles in practice, responding primarily not to valuation levels but rather to something like our FCI growth impulse, an estimate of the impact of recent changes in financial conditions on the growth outlook. Currently, the FCI growth impulse points to a healthy boost over the coming year, strengthening the case for further tightening.
  • Leaving financial instability concerns out of the reaction function does not mean the policy stance has no role in reducing these risks. Our cross-country model of asset price busts shows that bust risk is substantially higher when the output gap is more positive, supporting the concern noted in the June minutes. This suggests that if the Fed is successful in containing overheating in the real economy, it can breathe at least a little easier about bubble risk.
  • To what degree might the FOMC view financial stability risk as an independent argument for higher rates? Research by Fed economists suggests that because credit growth has been only moderate, the optimal response of the funds rate to financial instability risk is very small. But this could cut both ways: the economy’s reduced dependence on debt relative to the last two cycles also implies less risk that moderate tightening will lead to a crash.
  • At this point, the FOMC does not need additional reasons for gradual further tightening, which a traditional reaction function based on the dual mandate suggests is already warranted. But Fed officials do appear more concerned about financial stability risks, and this could strengthen the case somewhat for tightening in the future.

The quandary would be promptly resolved, of course, if in the ongoing increasingly nebulous relationship between the Fed’s policy intentions and record high stock prices, which as Kevin Muir summarized simply as “stocks dare the Fed”, and are “about to make Dudley, Fischer and Yellen extremely nervous”, the Fed were to defy markets and unexpectedly hike rates once again, responding to the “dare”, and making it clear that the Fed is indeed focused first and foremost to threats to financial stability resulting from market “froth” and “bubbles“… which incidentally it itself has created.

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