When central banks try to talk up or talk down financial markets, they are said to be either ‘jawboning’ the market or conducting an ‘open mouth’ policy as opposed to the more traditional ‘open market’ policy that they conduct. In its semi-annual report presented to the US Congress in July, the Federal Reserve Board had the following comments on financial markets under the broad framework of ‘Financial Stability’:
However, signs of risk-taking have increased in some asset classes. Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms. Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened. For example, average debt-to-earnings multiples have risen, and the share rated B or below has moved up further for leveraged loans. The Federal Reserve continues to closely monitor developments in the leveraged lending market and, in conjunction with other federal agencies, is working to enhance compliance with previous guidance on issuance, pricing, and underwriting standards.
All hell broke loose in the US. Most commentators have taken exception to the Federal Reserve commenting on the valuation of small stocks and technology stocks. I am not sure I understand the breast-beating. You can read some of the criticisms here, here and here. One of them has appeared in ‘New York Times’ which is supposedly left-of-centre!
Disappointing that Gavyn Davies has joined in the rebuke of the Federal Reserve after reasonably sensible posts on the ‘natural rate of interest’ being different (too low) for global and globalised financial markets, even if it is too high for the US real economy. I guess he felt compelled to reaffirm his loyalty to the ‘Fed/Yellen mainstream’ lest be deemed a heretic. My jaw dropped when he opined that Martin Wolf had done a superb job of dissecting the BIS report. Well, they all close ranks or they have to. That is the rational thing to do for self-preservation and to continue to belong to the Club.
Well, let us come back to the Federal Reserve and what it said about asset prices.
The Federal Reserve has expressed an opinion and the all-knowing market participants should know what to do with it. If it is wrong, ignore it and if it turns out to be correct, thank the Fed.
Isn’t it the case that on several occasions, market participants look up to the Central Bank for guidance on interest rates and currencies – as to where their true value lies. Why should stocks be the exception?
Second, I am not sure I recall these folks criticising the Federal Reserve (and other central banks) when stock markets decline. Even in such situations, the Federal Reserve is taking a view that the market is undervalued and cuts rates to send that signal and push stock prices higher. I do not recall hearing a squeal.
The Central Bank is as much responsible (if not more) for financial stability as it is for output, employment and prices. It has as much right to conduct open-mouth and open market policies in pursuit of all of the above.
Those who need to shut up are the critics and not central banks.
Mind you, the Federal Reserve is not an anti-bubble central bank. If anything, Ms. Janet Yellen’s testimony went out of her way (as usual) to reassure the Congress on the continuation of accommodative monetary policy for a long time to come and for rates to stay below their natural rate well after employment and prices are near or at ‘mandate consistent’ levels (Consistent with the mandate of the Federal Reserve).
The criticism coming from market participants and the media (on behalf of the market participants) is to ensure that other central banks do not take the hint from the Federal Reserve and to discourage any further criticism or action on the part of the Federal Reserve Board.
If anything, the critics should have sharpened their knives on the Federal Reserve for pursuing its loose monetary policy even after presenting clear and strong evidence that quantitative easing and ultra-low interest rates have not helped boost business investment (Figure 20 in page 11 of the Monetary Policy Report) and productivity (Figure 28 in page 15).
Of course, they wont’ do that for they want to be part of the Fed/Yellen mainstream.
So much for human rationality, long-term thinking and learning from our mistakes.