While the last five years of super-easy Fed policy has not generated the economic growth or jobs as hoped for, stock prices have soared and lending standards are beginning to wane. It appears that stock prices are being driven more by valuation expansion than revenue growth, which is unsustainable, and could be indicative of a bubble. Easy policy has incentivized a rotation out of lower yielding securities to fund speculation in higher yielding assets and securities like stocks. There are also indications that commercial and industrial (C&I) loan lending standards are falling as banks desperately struggle for business, which could also be a sign of an impending bubble.
These indications seem all too familiar in an environment with a highly accommodative Fed. The question is can the Fed reverse its most accommodative policy in history fast enough to prevent another bubble and subsequent bust? The anticipated Fed plan of reducing Quantitative Easing (QE) purchases at $10 billion increments over the next seven meetings would not end the purchase program until the Dec. 16-17, 2014 meeting. At this pace by the time QE is phased out, and the zero interest rate tether is released, it might too late to prevent a third bubble in only 20 years. The Fed has a history of not switching to tighter policy aggressively enough after years of overtly easy policy.
In 2002, after two years of tech bubble deleveraging, a deflation scare prompted the Federal Reserve to conduct aggressive monetary policy aimed at lowering the inter-bank (Fed Funds) lending rate from over 5% to 1%. The easy policy incentivized risky spread trading, as institutions and individuals borrowed cheaply to fund speculation of higher yielding stocks and real estate. In 2004 with asset prices steadily rising, the Fed switched gears and began to tighten policy in an attempt to rein in the rampant run up.
Despite the change to tighter Fed policy, by the summer of 2005 stock and real estate prices had surged to a level that evoked concern of a bubble. Contrary to that concern, in a July 2005 interview with the then Chairman of Economic Advisors Ben Bernanke, Maria Bartiromo of CNBC asked, “What is the worst-case scenario? We have so many economists coming on our air saying ‘oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?” Bernanke responded, “Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.”
Bernanke’s unperturbed comments appeared grossly mis-guided less than two years later as a surge in subprime mortgage delinquencies led to sub-prime lender New Century filing for bankruptcy in April 2007. The Fed switched policy again and began implementing easy monetary policy in an effort to offset pending deflationary pressures. Shortly after the Fed began implementing lower interest rate policy, the over-levered U.S. economy awash with subprime mortgage debt finally collapsed as stocks and asset prices crashed.
Years of excessive credit had led to massive increases in stock and asset prices. The key being that the rise in prices was not fueled by increased productivity, it was fueled by increased availability of credit along with a social acceptance of using excess credit for gratuitous spending and speculation.
Figure 1 – The Fed Funds Target Inter-Bank Interest Rate