Has the Fed created the newest bubble?

Investors might be surprised to learn that they have a lot riding on something that they pay very little attention to: macro-prudential regulation, or what central banks and other government agencies do to reduce the risk of systemic financial disasters.

The aim of such regulation is to lower both the probability and potential costs of financial accidents. It does so by enhancing the resilience of the system, establishing circuit breakers to prevent problems in one area from contaminating others and, at the extreme, containing the detrimental impact on the broader economy when failures occur.

Macro-prudential regulation has been significantly enhanced in the aftermath of the global financial crisis. Authorities around the world have imposed higher and more intelligent capital requirements, required financial institutions to value their assets more conservatively and to hold more easy-to-sell assets, placed constraints on allowable risk-taking, insisted on more stable funding, and demanded greater provisions against bad loans.

The impact of the revamped regulation has gone far beyond the targeted banks and other financial companies. It has allowed central banks to be bolder in maintaining and evolving exceptional monetary and credit stimulus, which in turn has significantly bolstered the prices of stocks, bonds and other assets as a means of stimulating the economy.

The more confident central bankers are in their macro-prudential approach, the greater their willingness to persist with stimulus policies today that could involve a bigger risk of financial instability down the road -- a trade-off that has been noted recently by Minneapolis Fed President Narayana Kocherlakota, Boston Fed President Eric Rosengren and former Fed Governor Jeremy Stein.

Essentially, the Fed has been pushing stock and bond prices up to "bubblish" levels, in the expectation that they will inspire the kind of consumer spending, physical investments and hiring required to subsequently justify them. The hope is that the convergence will occur in the context of full employment and inflation near the Federal Reserve’s target of 2 percent. So far, though, the wedge between asset prices and economic reality remains large, as last week's juxtaposition of new stock-market highs and still-anemic wage-inflation data demonstrated.

The danger is that the economic recovery will ultimately fail to validate artificially high asset prices, leading to significant financial instability and adverse “spillback” for the economy. The more comfortable the authorities are in their ability to counter -- and, if necessary, contain -- such potential instability, the greater their appetite for maintaining the stimulus that markets so love.

The key question is whether the recent strengthening in macro-prudential regulation is sufficient to warrant the risks that the Fed is taking with respect to future financial instability.

Given the number of moving pieces in the global economy, I suspect that few are in a position to answer this question with sufficient precision and conviction. After all, the regulatory framework is still evolving, bank behavior has yet to adapt fully, some institutions remain too large to fail and manage, and some activities are migrating outside the direct purview of supervisors and regulators.

Macro-prudential progress, while notable, has fallen short of what national authorities initially envisaged, and international coordination has fallen short of what is needed to make it all work globally. Investors would be well advised to take this into consideration in making their Fed-driven trades, especially if they involve positions that will be difficult to sell or unwind in more volatile markets.

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