Rising interest rates mean the US Federal Reserve is back to the fundamentals, and that’s reason to celebrate
- Stephen S. Roach says the Fed tightening shows the central bank is returning to a reliance on market fundamentals, ending the era of asset-friendly easy money
Since the October 19, 1987, stock market crash, investors have learned to count on the Fed’s unfailing support, which was justified as being consistent with what is widely viewed as the anchor of its dual mandate: price stability. With inflation as measured by the Consumer Price Index averaging a mandate-compliant 2.1 per cent in the 20-year period ending in 2017, the Fed was, in effect, liberated to go for growth.
And so it did. But the problem with the growth gambit is that it was built on the quicksand of an increasingly asset-dependent and ultimately bubble- and crisis-prone US economy.
Greenspan, as a market-focused disciple of Ayn Rand, set this trap. Drawing comfort from his tactical successes in addressing the 1987 crash, he upped the ante in the late 1990s, arguing that the dotcom bubble reflected a new paradigm of productivity-led growth in the US. Then, in the early 2000s, he committed a far more serious blunder, insisting that a credit-fuelled housing bubble, inflated by “innovative” financial products, posed no threat to the US economy’s fundamentals. As one error compounded the other, the asset-dependent economy took on a life of its own.
Here, too, the Fed’s tactics owe their origins to Bernanke’s academic work. With his colleague Mark Gertler of New York University, he argued that while monetary policy was far too blunt an instrument to prevent asset bubbles, the Fed’s tools were far more effective in cleaning up the mess after they burst. And what a mess there was! As Fed governor in the early 2000s, Bernanke maintained that this approach was needed to avoid the pitfalls of Japanese-like deflation. Greenspan concurred with his famous “mission accomplished” speech in 2004. And, as Fed chair in the late 2000s, Bernanke doubled down on this strategy.
For financial markets, this was nirvana. The Fed had investors’ backs on the downside and, with inflation under control, would do little to constrain the upside. The resulting “wealth effects” of asset appreciation became an important source of growth in the real economy. Not only was there the psychological boost that comes from feeling richer, but also the realisation of capital gains from an equity bubble and the direct extraction of wealth from the housing bubble through a profusion of secondary mortgages and home equity loans. And, of course, in the early 2000s, the Fed’s easy-money bias spawned a monstrous credit bubble, which subsidised the leveraged monetisation of housing-market froth.
The Fed, it is to be hoped, is finally coming clean on the perils of asset-dependent growth and the long string of financial bubbles that has done great damage to the US economy over the past 20 years. Just as Paul Volcker had the courage to tackle the Great Inflation, Jerome Powell may well be remembered for taking an equally courageous stand against the insidious perils of the asset economy. It is great to be a fan of the Fed again.