Central bankers intervene when global economies crash, but they shouldn't act to prevent economies from coming off the rails.
That seems like an odd strategy, but that was, in essence, the argument made by Janet Yellen, the head of the Federal Reserve, in a speech at the International Monetary Fund in late June. She said it's a bad idea to raise rates to fight financial excesses, some of which, it should be noted, have been created by the Fed and other central banks around the world.
Yellen said that the Fed's "monetary policy faces significant limitations as a tool to promote financial stability," according to the New York Times. Monetary policy's effects aren't well understood on financial problems and "are less direct than a regulatory or supervisory approach." She also said adjusting interest rates would "increase the volatility of inflation and employment."
In effect, Yellen believes the Fed's way to help the financial sector withstand booms and busts is by policies such as increasing the amount of capital that banks must hold. Though in the speech, she conceded that higher interest rates in 2003 and 2006 might have slowed the rate of home price growth that created the housing bubble. But, she added, such increases wouldn't have done much to quell the rapid rise in housing prices but would have "weakened households' ability to repay previous debts." The net effect would have been to improve "household balance sheets only modestly."
What's most disturbing about her comments is that her central bank colleagues in other countries deeply disagree with this position. They argue that low rates caused by central bank stimulus programs may be sowing the seeds for the next financial crisis.
The Bank of International Settlements, the institution in Basel, Switzerland that is the central bank for central banks, said in its recently released annual report! that stimulus programs that ignore the long term "run the risk of addressing the immediate problem at the cost of creating a bigger [financial crisis] down the road."
The S&P 500 Hitting Historical Highs: Is the Market Bubble about to Burst?
Source: Y Charts
Many economists have warned that another financial bubble may be in the making as the same forces that are artificially propping up asset markets in the U.S. through central bank stimulus are also propping assets in various countries overseas.
Furthermore, central bank stimulus in the U.S., Japan, and China is having the unintended consequence of driving investors to buy assets overseas that may be overvalued or too volatile.
The bank said low interest rates and low volatility encourage investors "to take positions in the riskier part of the investment spectrum." It noted that in developed countries lots of low-rated debt was issued and lapped up by investors, as stock markets reached new highs. Also, some assets rose so high they lost touch with fundamentals, while at the same time volatility "in many asset classes approached historic lows."
And in the report, the BIS noted that, "the fallout from the financial cycle can be devastating. When financial booms turn to busts, output and employment losses may be huge and extraordinarily long-lasting. In other words, balance sheet recessions levy a much heavier toll than normal recessions."
Stagflation Risks Ahead
As my colleague Chief Investment Strategist Ben Shepherd reported last week in his report entitled, "The Fed's Dreaded Dilemma: A Weak Economy Plus Inflation," while the economy contracted at a greater than expected 2.9 percent in the first quarter of this year, in May the consumer price index (CPI) rose at an annualized 2.1 percent, its highest level since October 2012. Energy prices were up 5.8 percent from a year earlier, while food prices rose 2.1 percent. Even the Federal Reserve's own preferred me! asure of ! inflation, the personal consumption expenditures (PCE) index, popped up to 1.8 percent last month.
That the Fed's PCE index is showing inflationary pressure is significant, since it is essentially designed to lowball price increases. The CPI gives a 31 percent weighting to shelter costs and a 17 percent weighting to transportation (read as rent and gasoline), which the PCE basically cuts in half. By reducing the volatility of its preferred inflation gauge, the Fed essentially gives itself the leeway to maintain a looser policy longer, Shepherd said.
The Fed has said for years now that it would act when inflation reaches an annualized 2 percent, a level that is fast approaching. But according to Yellen's recent comments it not only appears the Fed risks being late to the inflation party, as we have long argued would likely happen, the central bank now risks not moving fast enough to arrest the consequences of a financial collapse for asset bubbles forming.
Certainly, Yellen is in a tough spot. If the Fed puts the brake on too soon it may kill any advances the economy has made in growth, which is still weak, but if she waits too long the central bank may not be able to contain inflation or pop a financial asset bubble before it bursts.
Despite the fact that inflation is clearly picking up, consumer spending has actually contracted over the past two months on an inflation-adjusted basis and is growing well below the pre-recession average of 5 percent. Incomes were also up by just 3.5 percent last month, another metric which typically ran above 5 percent for much of the two decades prior to 2008.
On June 3, the Labor Department reported the economy accelerated, with employers adding 288,000 jobs, well above the rate of hiring recorded in the first five months of 2014 and another sign that growth may be finally rebounding. The Labor Department also reported the unemployment rate fell 0.2 percentage point to 6.1 percent, the lowest since September 2008, at the time the gl! obal fina! ncial crisis occurred.
Wishing our readers a happy Fourth of July holiday, from the investment team at Inflation Survival Letter.
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