econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 03 July 2017

Why A Market Dislocation Could Be Good For The Economy

by Gene D. Balas

Well, the headline may be a bit extreme and dramatic, but there are reasons why some restraint in asset prices may tighten financial conditions just enough, so the Fed doesn’t have to hit the brakes quite as hard. Recently, Fed Chair Janet Yellen, Fed Vice Chair Stanley Fischer, and San Francisco Fed President John Williams have all mentioned rich valuations (meaning loose financial conditions with high stock prices and low bond yields) as concerns in recent speeches.

balas.calc.caption


Please share this article - Go to very top of page, right hand side for social media buttons.


In a speech devoted to financial stability concerns, Fed Vice Chair Fischer observed,

“Prices of risky assets have increased in most major asset markets in recent months even as risk-free rates also rose. In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows."

Let’s delve into why they believe high asset prices may be problematic, and why a bit tighter financial conditions may be good for the economy.

First, what do we mean by tightening financial conditions? One example of loose financial conditions is that longer term interest rates are quite low, with the ten-year Treasury yielding about 2.2%, when the Fed believes the fed funds rate will eventually settle in the range of about 2.75% to 3% or so in the long run. Given that, it might be reasonable to expect longer term bonds to yield more than they are. Then there is the stock market that is trading with price-to-earnings and price-to-book ratios that are elevated compared to history, according to Bloomberg data. Credit spreads for high yield corporate bonds are quite low relative to history, according to data from the St. Louis Fed. All of these are examples of loose financial conditions.

Why is this a concern? Well, for starters, consider the past three recessions and the financial conditions that led up to them. In the late 1980s, we had commercial real estate that had risen a bit excessively prior to the 1990 recession. In the 1990s, we had the tech bubble, prior to the 2001 recession. Then we had the housing bubble.

Each of these three financial predicaments led to a degree of overheating that required the Fed to step in, resulting in an arguably already-unstable economy toppling over under its own weight. Instead, better to have had financial markets that were neither too tight nor too loose to begin with. That may have resulted in a bit less economic enthusiasm, with businesses and consumers not taking advantage of too-low rates or too-high stock valuations to spend and invest with abandon, ignoring fundamentals and gorging on newly raised debt or equity capital.

But how loose are financial conditions, anyway? Consider the following graph from the Chicago Fed. It measures risk, liquidity and leverage in money markets and debt and equity markets as well as in the traditional and “shadow" banking systems. When it is below zero, financial conditions are looser, while positive values represent tighter financial conditions.

Click for large image.

financial conditions and fed funds.png

When conditions are too loose, bubbles can form or inflation can percolate. Juxtaposing the fed funds rate with the measure of financial conditions, the above graph illustrates how loose financial conditions generally beget Fed tightening cycles. Eventually, with a lag, that shows up in tighter financial conditions. It’s just that sometimes those tighter financial conditions became so tight a recession developed and we had a bear market. If the financial markets tighten a bit on their own, it may alleviate concerns of financial conditions being ripe for instability to creep in. At the very least, it makes the job of the Fed easier, potentially allowing for rates to rise more slowly and possibly settling at a lower level than would otherwise be the case.

As you will note in the above graph, financial conditions were especially loose as both the tech bubble and housing bubble inflated. The Fed does not want to be behind the curve, but inflation in goods and services in the current environment is still is low, and below the Fed’s target. This puts the Fed in a bit of a dilemma: arguably, interest rates should be a bit higher - especially given stock market valuations and low bond yields - if only inflation was responding as one might have expected, at least given textbook formulas. As I wrote in May, however, those relationships seem to have broken down recently.

If conditions were following textbook theory, we can see just where interest rates might be. Consider the following graph which shows how the fed funds rate has tracked nominal potential GDP - not actual GDP, but the rate at which the economy can grow and maintain full employment without triggering inflation. Basically, real potential GDP is roughly the sum of the growth of the labor force plus productivity gains, and nominal potential GDP includes the addition of reasonable inflation expectations.

Click for large image.

potential GDP and fed funds rate.pngThe fed funds rate is well below where nominal potential GDP currently is and is expected to be. Indeed, in the Fed’s own forecasts, published following its March meeting, it believes the fed funds rate should settle around 2.75% to 3.0% in the long run, or in the rough neighborhood of where nominal potential GDP would be (the red line in the chart).

However, there’s a little problem with simply thinking borrowing rates are too low: businesses are not as willing to borrow as they once were. If companies aren’t borrowing, that could be an early indication that the economy might be slowing, or is about to slow, or that low rates aren’t encouraging rampant demand for credit the way a simple model might suggest. If low rates aren’t fueling excessive borrowing, what need is there to raise rates?

Click for large image.

commercial and industrial loans.png

This is especially true given how low inflation has been. While some Fed officials may want to proceed with normalization at a steady pace, and some see a need for higher rates based on high asset prices, others may argue for a slower, wait-and-see approach. Consider Fed Governor Lael Brainard’s comments in the Q&A following a recent speech:

“I do believe that the neutral [interest] rate is very low, that we are not far at all from neutral, and I don’t have a strong amount of confidence that it’s going to rise rapidly from where we are today."

But, of course, if the Fed were to want to hold rates low, that would also require markets to do their part to tighten financial conditions, at least just a bit, as well.


Disclosure: Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.


>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical Opinion Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted. You can also comment using Facebook directly using he comment block below.




Econintersect Opinion








search_box
Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.







Keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government





























 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2017 Econintersect LLC - all rights reserved