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MNI: Fed Willing To Risk Bubbles To Achieve Jobs, Price Goals

MNI (Washington)
WASHINGTON (MNI)

U.S. central bank aware of its own role in fueling asset prices, but still lacks good tools to control them

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Federal Reserve officials recognize their policies may be helping to inflate asset bubbles, but view this as a risk worth taking for the sake of the broader economy and hope strong growth prospects will prevent a serious market crash, current Fed advisers and former officials told MNI.

The Fed's patient stance, with the central bank determined to keep policy easy until it achieves concrete economic outcomes, may soon face a stern test as it struggles with market trepidation ahead of potentially elevated inflation readings in coming months, they said.

"Their preference would be slow slow slow, to ideally pull this off without rattling markets -- but it's not up to them," former Fed governor Jeremy Stein said in an interview.

"If at some point the market gets it in its head there's a bit of an inflation problem and the Fed just keeps saying we're looking through it, then you worry about long-term inflation breakevens spiking. Their hand might be forced."

Fed Chair Jerome Powell said at last week's press conference he is not worried about what he predicts will be transitory price spikes accompanying the economy's reopening from Covid. While he came the closest so far to declaring markets, particularly "frothy" equities, to be in a bubble, he signaled the Fed will look through this in order to achieve stronger employment outcomes and raise inflation from the sub-2% target levels that predominated after the Great Recession.

FOCUSED ON FULL EMPLOYMENT

"The Fed is more than willing to risk an asset bubble if it means better outcomes for Main Street," said Diane Swonk, an economist who regularly advises the Fed's board of governors in Washington and the Chicago Fed. "This is a Fed that's working for the real economy and not for Wall Street."

She said investors haven't quite wrapped their heads around a chair who talks openly about social issues in a way that many did not expect, and appears committed to meeting the Fed's more inclusive employment goals. Many still believe the central bank will flinch at the first sign of prices rising despite its framework shift.

"The reconciliation could be quite messy," Swonk said.

Richard Berner, former head of the Treasury's Office of Financial Research, told MNI he is "more concerned about financial stability issues than their rhetoric implies."

"If they were willing to modify their communication a little bit, to become more willing to talk about how they might employ some tools to ensure financial stability, that would give me some comfort," he said.

COVID RESPONSE PLANTED BUBBLE SEEDS

Stein added that "elevated asset prices are partly the result of the Fed's efforts to prevent the pandemic from spiraling, for which they deserve great credit. But now that you have it, it's tricky.

"If they start to withdraw or signal they'll taper sooner, I think financial markets could be pretty fragile. But if they don't, and people are worried about inflation and they see the Fed not willing to do anything, what does that do to rates?"

The Fed stepped up its bond buying as soon as the scope of the pandemic became clear in March 2020. It has purchased a monthly USD120 billion worth of Treasury and mortgage bonds since and vows to keep doing so until it sees "substantial further progress" in the economy, a marker that is edging only gradually closer.

The central bank has signaled it does not intend to begin raising interest rates until its employment and price stability goals are all but fully met, a shift from its past approach of moving on the basis of forecasts.

"I am less worried about froth in the financial markets for the U.S. -- the financial system has some slack so that deflating of froth won't have significant macro consequences for the United States," said Arvind Krishnamurthy, who has consulted for the Fed board and a range of regional Fed banks, and presented a paper at the Fed's flagship Jackson Hole conference in 2019 and 2013.

"I am worried about the uncertainties surrounding inflation, more so than what is sure to be a bout of inflation in the next year."

Bank of America's April survey of credit investors found what the bank described as a paradigm shift -- Covid no longer tops the list of risks, having been replaced instead by angst over bubbles and debt sustainability.

"I think they're making a mistake in not being more forthcoming about the costs of their framework shift," ex-New York Fed President William Dudley said in an interview.

"They may get criticized quite a bit when reality turns out to be more painful."