Why the US Federal Reserve should care about finance

Emerging market stocks, last year’s darlings, are collapsing. does this mean the bubbles of an artificially inflated market are finally bursting? it’s a question worth asking a decade on from 2008. As every Financial Times reader knows, the world’s central bankers were responsible for ensuring that the Great Recession did not become another Great Depression by keeping interest rates low and holding an eye-popping $15tn on their balance sheets.

This led to stock markets reaching all-time peaks, even as it has failed to create any sort of real wage growth. Central banks can create asset bubbles, of course, but they cannot change the wage-suppressing effects of globalisation, technology-driven deflation, and an increasing concentration of corporate power that makes it impossible for workers in rich countries to have any real bargaining power.

I am not faulting the US Federal Reserve, the European Central Bank or any of the other institutions that have run the world’s largest-ever experiment in unconventional monetary policy — although I would argue that, by this point, it is not so unconventional.

Since Alan Greenspan’s era in charge of the Fed, the bias has been to leave rates low and worry about the inevitable asset bubbles later. It is an understandable attitude, particularly given the inability of politicians in the developed world to push through big infrastructure plans, or educational reform, or other things that would actually change things for ordinary people, over the past 10 years.

But it is clear that we have reached the boundaries of what easy money can constructively do. When 10 per cent of the USpopulation owns 84 per centof the shares, asset price increases do not create inflation, but inequality.

While Fed chair Jay Powell’s first major speech at Jackson Hole last month made it clear he would not move away from business as usual any time soon, I was most intrigued by a single passage at the very end. It seemed to indicate the Fed knows the current strategy isn’t really working any more.

“Inflation may no longer be the first or best indicator of a tight labour market,” he said, noting that “in the run-up to the past two recessions, destabilising excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.”

Translation? The Fed chief is admitting that financialisation exists and the markets are now the tail that wags the dog. Central bankers and most economists tend to work with a model that assumes economic downturns create market downturns. But Mr Powell is hinting that the reverse may be true.

This is a big deal. But it is not really a new insight. Far from being a blind follower of “markets know best” efficiency theory, Mr Greenspan himself was well aware that easy monetary policy and stock prices could create bubbles in the market that may have terribly damaging real-world effects (he wrote a paper on the topic in 1959).

Why, then, did Mr Greenspan, and every Fed chief since, allow bubbles to expand and burst rather than getting out in front of them?

The particulars depend on the regime. Despite his sideways references to “irrational exuberance”, Mr Greenspan was a finance-friendly regulator who did not want the music to stop. His successors, Ben Bernanke and Janet Yellen, believed that low interest rates were the only thing standing between the American population and the breadline. Either way, politicians have never made it easy for central bankers to take the punch bowl away.

Does anyone doubt that this mega-bubble will eventually burst? When it does, the results will inevitably ripple through the real economy (academic research shows that most recessions since the second world war followed stock market collapses).

It is possible that the current downturn in emerging market stocks could spread and be the trigger for the economic slowdown that most people believe is coming in the next couple of years. Given this, I would argue we should drop the “wait and see” approach to monetary policy. Ten years after the crisis, and four decades after interest rates began their steady decline, it is time for a fresh approach to monetary policy.

What might this entail? For starters, central bankers should make financial markets a more central part of their models. It is amazing that they are not already front and centre, given the rise of financialisation since the 1980s. Mr Powell admitted that “inflation sends a weaker signal” now than in the past, which makes it important to look elsewhere for signs of overheating.

What metrics might the Fed and other central banks look at? I suggest three. First, the pace of run-up in debt, always the biggest predictor of market trouble. It has been growing more rapidly than gross domestic product for a number of years. The growth of financial assets relative to GDP is also near record levels. Margin debt, ditto.

Or, just take a walk around Brooklyn, where I live. In Bedford-Stuyvesant, a neighbourhood where street shootings are still an issue, a townhouse recently sold for $6.3m. As was the case before 2008, sometimes the best economic indicators are the ones next door.


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