The Wall Street Journal - Fed’s Effort to Guide Markets Falls Short
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June 11, 2017. David Harrison.
Moves to rein in financial conditions appear to be having little impact.
The Federal Reserve and financial markets are dancing out of step: The Fed is trying to lead but markets refuse to follow.
Fed officials, trying to prevent the economy and markets from overheating, are slowly raising short-term interest rates and moving to shrink their large portfolio of Treasury and mortgage bonds. But while the Fed tries to take fuel out of the financial system, stocks are rallying and bond yields falling, developments that could prompt more borrowing, faster economic growth and more market speculation.
The tech-heavy Nasdaq Composite stock index is already up 17% as it nears the midyear mark and the S&P 500 index a robust 9%. Yields on 10-year Treasury notes have dropped to their lowest levels since November, meaning borrowing costs are falling for many households and businesses even as the Fed tries to raise them.
Broad financial conditions are as accommodative now as they were in early 2015, the point of maximum Fed stimulus, according to a closely watchedGoldman Sachs index, which measures the combined impact of movements in interest rates, stock prices and the value of the dollar.
All this, even though the Fed has raised interest rates three times since December 2015 and will likely announce another increase at its June 13-14 meeting. Officials are also working on a mechanism to unload some of the Treasury and mortgage securities they bought in the aftermath of the recession.
Easy financial conditions create a risk the market could overheat and then snap back, sending yields soaring and choking off lending, said Torsten Slok, chief international economist at Deutsche Bank Securities. “The rubber band is stretching out here.”
In theory, financial conditions should serve as the conduit between the Fed’s monetary policy and the real economy. When the Fed lifts short-term rates, long-term rates should rise also and financial conditions should tighten.
The fact that the central bank and Wall Street are moving in opposite directions suggests limits to the Fed’s influence over the economy. If it persists, it could also prompt the Fed to shift its strategy. If your dance partner doesn’t follow, you might hold that person tighter.
“If we decide that we need to tighten financial conditions and we raise short-term interest rates and that doesn’t accomplish our objective, then we’re going to have to tighten short-term interest rates by more,” New York Fed President William Dudley told The Wall Street Journal last year.
It is still too early to say whether officials will raise rates more aggressively than planned. Still, Harvard University economist Jeremy Stein, a former Fed governor, said because financial conditions are so loose after three rate increases, the Fed is less likely to back away from its plan to keep raising rates, even in the face of low inflation.
Markets could be underestimating the Fed’s willingness to pursue its stated path of raising rates twice more this year. Investors are broadly split over whether the Fed will manage more than one additional move in 2017, according to CME Group data.
Fed officials note it takes time for their policy moves to translate through to markets and the broader economy. That lag makes it difficult for them to perfectly engineer financial conditions and raises the risk the Fed could overreact and cut off credit.
Today’s disconnect is reminiscent of the 2004-2006 period, when financial conditions stayed loose even as the Fed raised its benchmark interest rate by 4.25 percentage points. Former Fed Chairman Alan Greenspan called it a “conundrum.” His successor, Ben Bernanke, suggested long-term borrowing costs were kept down by rapidly developing countries in Asia pouring U.S. dollar holdings—accumulated through large trade surpluses—into Treasury securities, a phenomenon he called the “global savings glut.”
Those loose financial conditions helped inflate the housing bubble that led to the financial crisis in 2007.
Today, many economists and central bankers once again say the split between Fed policy and market conditions is due to developments over which the Fed has little control.
Aggressive central bank stimulus in the eurozone and Japan has pushed down borrowing costs in those countries. That’s prompted investors there to look to U.S. government debt for better returns, pushing up the price of long-term Treasury securities and driving down yields, said Mr. Stein.
Meanwhile, expectations that the Trump administration would usher in a growth-boosting tax overhaul are waning, pushing Treasury yields down. The long-lagged effects of super easy monetary policy may also be accumulating in stock values.
Moreover, the global economy has picked up this year, which boosts equity prices while weakening the dollar. China’s efforts to stabilize its currency by selling U.S. assets have put added downward pressure on the dollar.
Fed governor Jerome Powell told an audience this month he wasn’t yet concerned about the similarities to the precrisis era.
At least for now.
“If something like that does persist, then I think it’s something you need to take into account in setting monetary policy,” he said. “It’s premature to be doing that today.”
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