To Control Bubbles, the Fed Needs to First Control Itself

Includes: DIA, SPY
by: David Merkel, CFA

I’ve written before about the Fed’s de facto triple mandate:

  1. Low goods-price inflation.
  2. Low labor unemployment.
  3. Protect the financial system in a crisis.

Number 3 is the implicit obligation of the Fed, for several reasons:

  • The Fed carries out monetary policy (in ordinary times) through the banks.
  • Banks in the Federal Reserve System have close ties to the regional Federal Reserve Banks.
  • Bankers and those sympathetic to bankers comprise a large portion of the leadership and staff of the Federal Reserve.
  • Regulating banks gives jobs to many at the Fed.

Stepping back, let me tell you a story. In the mid-90s, I became worried about inflation going out of control again, given the degree of monetary growth that I saw. I’m not sure where I got the idea, but eventually it struck me that in the ’70s, when inflation was running hot, we had a lot of spenders and few savers. In the ’90s, more savers and fewer spenders. (You have to add in agents of the baby boomers, including the defined benefit plans, and the growth in 401(k)s, and products like them.) Goods weren’t inflating from excess money, assets were being inflated as the baby boomers were socking away funds for retirement.

(Note to stock investors: be wary when market P/Es rise dramatically — there are limits to what is reasonable in P/Es for any level of corporate bond yields. This applies to price-to-book and -sales ratios as well.)

As one more example of how monetary policy affects the asset markets, consider how the Fed temporarily flooded the banks with liquidity to avert problems regarding Y2K, and the stock markets reacted to the excess liquidity with a two month lag. The Fed helped put in the top of the tech bubble. I don’t know how the money leaked out of the banks to the stock market, but excess reserves under good conditions will produce loans.

Thus, I came to the conclusion that the Fed ought to look at asset inflation as well as goods inflation somewhere in the late ’90s. But doesn’t the implicit third mandate cover that? Alas, no, the third mandate is reactive, not proactive. It kicks in after a crisis hits — Greenspan then floods the market with liquidity, and only steps back when things are running hot again.

A proactive policy would limit the degree of easing that the FOMC could do — once the spread of ten-year Treasuries over two-year Treasuries exceeds 1%, all easing would stop. The banks can easily make money with a yield curve that steep… not much money, but enough to keep them alive (the financial sector would shrink under these rules). There would be a second rule that when the spread of ten-year Treasuries over two-year Treasuries is less than 0%, all tightening would stop. During times of extreme inflation or unemployment, these rules could be waived by Congress for a year at a time. But that lays the policy back at the door of Congress, which represents the people and the states, where the decision belongs.

A policy like this eliminates the risk that the Fed can steepen the yield curve dramatically, leading to bubble creation — the excess credit has to go somewhere. Another limit on the Fed could be a limit on total leverage in the economy — above a certain limit, such as 2x GDP, the Fed raises the Fed funds rate, regardless of the unemployment situation, until indebtedness falls.

Bubbles are financing phenomena. Controlling bubbles can be done by controlling credit, and that is what the Fed tries to do — control credit, which is money in our era. (Until we go back to something better, and get the government out of the money business — some sort of commodity standard.)

The present Fed holding action inflates assets not goods. By offering financing to asset markets that are in disarray, it supports asset prices. For now, none of that balance sheet expansion leaks out to the general public, and thus, little goods inflation. But also, little true stimulus.

In short, the Fed should limit its powers to reliquefy the economy, because sloppy efforts in the past 25 years produced the popped bubbles that we are now dealing with. Better to leave policy tight longer, and not loosen so much in troubles. Don’t worry, we might have to wait longer for recovery, but the recoveries will be sounder when they come.

Parting Shots