What If the Fed Has Created a Bubble?
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 (stress tests, capital requirements etc) 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.