Monday, July 24, 2017

The Repercussions of the Federal Reserve's Monetary Experiment

With the Federal Reserve finally making moves toward normalizing monetary policy by raising interest rates and reducing the size of its bloated balance sheet, it's an interesting exercise to look at what has motivated this move outside of the supposed health of the economy.  As you will see in this posting, there is a repeated theme in comments made by various Federal Reserve insiders.

Let's start with the head of the Federal Reserve.  Here's a recent exchange from Janet Yellen's July 12, 2017 testimony before Congress on the subject of asset prices: (starting at the 57 minute 55 second mark):

Ms. Carolyn Maloney (D - NY 12th):  The Fed has suggested that the stock market is currently overvalued.  Are there other markets that you consider or see as overvalued as well and do you think a correction in any of these markets would cause problems for financial stability?

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

Here's Eric Rosengren, President Federal Reserve Bank of Boston from a speech given May 9, 2017 entitled "Trends in Commercial Real Estate":

"While an overheated economy followed by a recession is only one possible scenario, and certainly not my prediction, it helps to illustrate one way in which low cap rates might be of concern in the event of such a reversal. While all market participants should consider how their positions would be impacted by adverse scenarios, Figure 15 shows that leveraged institutions and government-sponsored entities have significant exposures to commercial real estate. In the
event of an adverse scenario such as a recession, these exposures could pose significant risks to these institutions.

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."

Here's Figure 15 which shows that the banking sector has been a massive investor in commercial real estate, currently owning 53 percent of the total, up 9.6 percent on a year-over-year basis:

Here's Jerome Powell, Member of the Board of Governors of the Federal Reserve from a speech given January 7, 2017 entitled "Low Interest Rates and the Financial System":

"Low-for-long interest rates can have adverse effects on financial institutions and markets through a number of plausible channels, as listed on the next slide.  After all, low interest rates are intended to encourage some risk-taking.   The question is whether low rates have encouraged excessive risk-taking through the buildup of leverage or unsustainably high asset prices or through misallocation of capital.  That question is particularly important today. Historically, recessions often occurred when the Fed tightened to control inflation.  More recently, with inflation under control, overheating has shown up in the form of financial excess.  Core PCE inflation remained close to or below 2 percent during both the late-1990s stock market bubble and the mid-2000s housing bubble that led to the financial crisis.  Real short- and long-term rates were relatively high in the late-1990s, so financial excess can also arise without a low-rate environment.  Nonetheless, 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."

Here is slide 8 from his presentation which shows the risks associated with "low-for-long interest rates":

Here's Stanley Fischer, Vice Chairman of the Federal Reserve from a speech given June 20, 2017 entitled "Housing and Financial Stability": 

"It is often said that real estate is at the center of almost every financial crisis. That is not quite accurate, for financial crises can, and do, occur without a real estate crisis. But it is true that there is a strong link between financial crises and difficulties in the real estate sector…. 

But memories fade. Fannie, Freddie, and the Federal Housing Administration are now the dominant providers of mortgage funding, and the FHLBs have expanded their balance sheets notably. House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates...

But there is more to be done, and much improvement to be preserved and built on, for the world as we know it cannot afford another pair of crises of the magnitude of the Great Recession and the Global Financial Crisis."

Here's John Williams, President Federal Reserve Bank of San Francisco from an interview on Australia Broadcasting Corporation television interview June 27, 2017 (11 minute 55 second mark): 

"We are seeing some reach for yield and some maybe excess risk-taking in the financial system with very low rates...

I am somewhat concerned about complacency in the market...The stock market still seems to be running pretty much on fumes.  It's very strong in terms of that.    It's something that clearly is a risk to the U.S. economy, some correction there -- it's something we have to be prepared for to respond to if it does happen."
And, last but not least, let's wrap up this posting by looking at what Janet Yellen had to say on 

June 27, 2017 in conversation with Nicholas Stern at the British Academy (1 hour 7 minute 45 second mark):

"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 ought to depend on long-term interest rates and of course there is uncertainty about, by standard  metrics some asset valuations look high but there's no certainty about that."

As I recall, the last time we heard about the abandonment of traditional metrics for stock valuations was back in the late 1990s and very early 2000s when measures like price-earnings ratios were tossed out the window when tech sector stock prices were unhinged from reality.  We all know how that movie ended, don't we?

Here is a chart showing the trailing price-to-earnings ratio for the S&P 500 going back to 1987:

While not at the levels seen during the tech stock boom (or during the extraordinary period during  the Great Recession's plunge in profits), the PE ratio certainly appears to be reaching the point of  being "rich".

While the braintrust at the Federal Reserve rarely show their hand, there seems to be a subtle yet repeated comments about the possible negative repercussions of their long-term near-zero interest rate policies, in particular, the impact on asset prices.  One would think that they learned from their experiences with low interest rates and the bubble created in the American housing market but, apparently, some lessons are harder learned than others.

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