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Rudi Dornbusch, the late MIT professor, once famously said of the Mexican Central Bank that he could understand their having made mistakes. For after all, they were only human. However, what he could not understand was how the same people could have made the same mistakes time after time.

On considering the global asset bubbles that the US Federal Reserve has been inflating by its unprecedented balance sheet expansion over the past 18 months, one has to wonder whether the same might not be said of the Fed as was said of the Mexican Central Bank. This now has to have been the third time in the past 15 years that the Fed has blown asset price bubbles through its excessively easy monetary policy stance. And seemingly the Fed learns nothing from the subsequent bursting of these bubbles.

Yesterday's sobering Annual Report from the Bank for International Settlements (NASDAQ:BIS), the Basel-based bank of the world's central banks, provides a slew of information supporting the view that excessively buoyant global financial markets have become largely disconnected from the rather lackluster economic performance of recent years. Despite the most mediocre of economic recoveries from the Great Economic Recession, global equity markets have skyrocketed to new record highs and volatility indices sunk to all-time lows. Global credit markets too have reduced interest rates for risky borrowers in the corporate high-yield market and in the European economic periphery space to levels that almost certainly do not price in historic probabilities of default.

Fed Chair Janet Yellen's recent repeated denials that US equity and credit markets might be frothy would seem to underline the point that the Fed keeps making the same mistake of first denying and then underestimating the cost of asset price inflation by largely restricting its policy focus to employment and goods price inflation. The Fed did so first with the technology bubble at the start of the 2000s, it then did so again with the housing and credit market bubble in the mid-2000s, and currently it seems to be again doing so with the global equity and credit market bubbles.

The BIS, whose earlier warning to the Fed in the run-up to the housing and sub-prime bust in the mid-2000s went unheeded, is now warning the Fed about the dangers of excessively buoyant global financial markets. In that context, it is urging the Fed to pay attention not only to the economic cycle but also to the financial market cycle, which is often of a longer duration than the economic cycle. Hopefully, Mrs. Yellen will heed the BIS's advice this time around by not responding to any further weakening in the US economy by yet more quantitative easing. For if she chooses not to do so, we should brace ourselves for another nasty episode of asset price bursting once US interest rates eventually start to normalize.

Source: Blowing Bubbles At The Federal Reserve