Why A Market Dislocation Could Be Good For The Economy

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by: Gene Balas, CFA

Summary

Financial conditions that are too loose have the potential to cause bubbles in asset prices and ignite inflation beyond the Fed's target.

Right now, financial conditions are considerably looser than average, and loose financial conditions often require the Fed to tighten rates.

However, businesses' borrowing growth has been notably less than it had been in recent years. If loan growth is tapering off, would rates really need to be higher?

Interest rates are below levels where the Fed and models suggest they should be, but if the Fed tightens before the market can bear added tightening, a recession can ensue.

If financial markets tighten a bit on their own, that would alleviate the need for the Fed to have to intervene by raising rates faster or higher than it desires.

Well, the headline may be a bit extreme and dramatic, but there are reasons why some restraint in asset prices may tighten financial conditions just enough, so the Fed doesn't have to hit the brakes quite as hard.

First, what do we mean by tightening financial conditions? One example of loose financial conditions is that longer term interest rates are quite low, with the ten-year Treasury yielding about 2.2%, when the Fed believes the fed funds rate will eventually settle in the range of about 2.75% to 3% or so. Given that, it might be reasonable to expect longer term bonds to yield more than they are. Then there is the stock market that is trading with price-to-earnings and price-to-book ratios that are elevated compared to history, according to Bloomberg data. Credit spreads for high yield corporate bonds are quite low relative to history, according to data from the St. Louis Fed. All of these are examples of loose financial conditions.

Why is this a concern? Well, for starters, consider the past three recessions and the financial conditions that led up to them. In the early 1990s, we had commercial real estate that had risen perhaps a bit excessively. In 2001, we had the tech bubble. Then we had the housing bubble.

Each of these three financial predicaments led to a degree of overheating that required the Fed to step in, resulting in an arguably already-unstable economy toppling over under its own weight. Instead, better to have had financial markets that were neither too tight nor too loose to begin with.

On the other hand, tighter financial conditions may have resulted in a bit less economic enthusiasm, with businesses and consumers not taking advantage of too-low rates or too-high stock valuations to spend and invest with abandon, ignoring fundamentals and gorging on newly raised debt or equity capital.

But how loose are financial conditions, anyway? Consider the following graph from the Chicago Fed. It measures risk, liquidity and leverage in money markets and debt and equity markets as well as in the traditional and "shadow" banking systems. When it is below zero, financial conditions are looser, while positive values represent tighter financial conditions.

When conditions are too loose, bubbles can form or inflation can percolate. Juxtaposing the fed funds rate with the measure of financial conditions, the above graph illustrates how loose financial conditions generally beget Fed tightening cycles. Eventually, with a lag, that shows up in tighter financial conditions. It's just that sometimes those tighter financial conditions became so tight a recession developed and we had a bear market. If the financial markets tighten a bit on their own, it may alleviate concerns by the Fed of financial conditions being ripe for instability to creep in. At the very least, it makes the job of the Fed easier, potentially allowing for rates to rise more slowly and possibly settling at a lower level than would otherwise be the case.

As you will note in the above graph, financial conditions were especially loose as both the tech bubble and housing bubble inflated. The Fed does not want to be behind the curve, but inflation in goods and services in the current environment is still is low, and below the Fed's target. This puts the Fed in a bit of a dilemma: arguably, interest rates should be a bit higher - especially given the valuations of the stock market and certain other assets - if only inflation was responding as one might have expected, at least given textbook formulas. As I wrote in May, however, those relationships appear to have broken down recently.

If conditions were following textbook theory, we can see just where interest rates might be. Consider the following graph which shows how neatly the fed funds rate has tracked nominal potential GDP - not actual GDP, but the rate at which the economy can grow and maintain full employment without triggering inflation. Basically, real potential GDP is roughly the sum of the growth of the labor force plus productivity gains, and nominal potential GDP includes the addition of reasonable inflation expectations.

The fed funds rate is well below where nominal potential GDP currently is and is expected to be. Indeed, in the Fed's own forecasts, published following its March meeting, it believes the fed funds rate should settle around 2.75% to 3.0% in the long run, or in the rough neighborhood of where nominal potential GDP would be in the years ahead (the red line in the chart).

However, there's a little problem with simply thinking borrowing rates are too low: businesses are not as willing to borrow as they once were. If companies aren't borrowing, that could be an early indication that the economy might be slowing, or is about to slow, or that low rates aren't encouraging rampant demand for credit the way a simple model might suggest. If low rates aren't fueling excessive borrowing, what need is there to raise rates?

This is especially true given how low inflation has been. While some Fed officials may want to proceed with normalization at a steady pace, others may argue for a slower, wait-and-see approach. Consider the views Fed Governor Lael Brainard shared in a recent speech:

"I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing," Brainard said. "If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today."

Her comments in the Q&A following her speech might sum up today's environment perfectly: "I do believe that the neutral rate is very low, that we are not far at all from neutral, and I don't have a strong amount of confidence that it's going to rise rapidly from where we are today." But, of course, that would also require markets to do their part to tighten financial conditions, at least just a bit, as well.

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