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Time For The Fed To Take Away The Punch Bowl?

Filed by KOSU News in Business.
March 6, 2013

The stock market’s long climb from its recession bottom has some people concerned it may be a bubble about to burst — a bubble artificially pumped up by the Federal Reserve’s easy-money policy. That’s led to calls — even from within the Fed — for an end to the central bank’s extraordinary efforts to keep interest rates low.

Even as the Dow Jones industrial average was reaching its nominal record Tuesday, Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, continued his criticism of the central bank’s massive intervention, calling it unhealthy. Another regional Fed president, Charles Plosser of Philadelphia, told a gathering of Pennsylvania businessmen that the Fed’s easy-money policy could cause financial instability and inflation. Plosser said it’s time for Fed policymakers to begin winding down their efforts to lower interest rates.

Causing A Stock Bubble?

Randall Kroszner, a former Fed policymaker and now a professor at the University of Chicago’s Booth School of Business, says as the economy heals, the debate over Fed policy is healthy.

“The fundamentals are starting to come back, and I think there’s a legitimate debate on whether more needs to be done,” Kroszner said.

But is the Fed’s low-interest-rate policy causing a bubble in the stock market? After all, there are still lots of things wrong with the economy. It’s still growing very sluggishly — not fast enough to bring down the unemployment rate, which remains high.

Alan Blinder, whose book After the Music Stopped deals with the financial crisis and the Fed’s extraordinary intervention, doesn’t think there’s a stock bubble. But Blinder, a former vice chairman of the Fed, says the central bank’s low-rate policy has pushed the market higher.

“Stock prices are supposed to depend on earnings and interest rates, and the Fed has made interest rates very low,” Blinder said. “But the other part of it is earnings are very high. You may have noticed that the share of national income accounted for by corporate profits has recently hit all-time highs.”

Nudging Investors To Take Risks

Blinder says with company profits soaring, it’s hard to make a case that their share prices are too high and there’s a bubble developing in stocks. And, he says, higher stock prices fit in with the Fed’s growth strategy: “To gently nudge — or maybe not so gently nudge — people into taking a little risk instead of putting all their money in Treasury bills and under the mattress.”

There are also worries that there’s a bubble developing in corporate bonds, and it’s true investors have driven corporate bond prices very high. But Blinder says it’s hard to consider that a bubble because it’s obvious why it’s occurred. The Fed’s policies have driven rates so low on government bonds that investors are chasing the higher yields on corporate bonds. But, Blinder says, they know the Fed’s extreme policy won’t last forever.

“So at some point these bond prices have to come down as interest rates go up,” he says. “And again, everybody knows that, but of course nobody knows the timing. Even [Fed Chairman] Ben Bernanke doesn’t know the timing.”

But when is the right time for the Fed to start to discourage the risk-taking party fueled by its low interest rates, or take away the spiked punch bowl, as the old analogy goes. That was on former Fed Chairman Paul Volcker’s mind when he spoke to the National Association for Business Economics in Washington on Monday.

“Because it’s never popular to take the so-called punch bowl away or weaken the liquor,” Volcker said. “And there’s a lot of liquor out there now. Mechanically, yeah, sure it can be done. They put it in, they can pull it out. But will it be done at the crucial time in a delicate kind of way? It’s gonna be a big challenge.”

The Fed raised interest rates too soon in the 1930s and smothered the economy. It moved too late in the 1970s and damaging inflation resulted. At least this Fed can learn from those mistakes. [Copyright 2013 NPR]

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