William McChesney Martin famously remarked that the job of the Federal Reserve is to remove the punchbowl just as the party gets going. When the Fed meets later this week, it might do well to heed Martin’s sage observation. With the clearest of signs that the U.S. economic party is in full swing, the least that the Fed should now be doing is to begin the process of winding down its present aggressive bond-buying program.
One sign that the party is already getting out of hand is seen in the bubbles forming in the equity and bond markets.
Fueled by the Fed’s ultra-low interest rate policy, U.S. equity valuations are now more than double their long-run average and at a level experienced only once before in the last 100 years. Meanwhile, fueled both by low interest rates and the Fed’s continued buying of $40 billion a month in mortgage-backed securities, the U.S. housing market is on fire. At a national level, housing prices are rising by 15 percent a year and are now higher than they were in 2006 on the eve of the housing market bust.
Our painful experience with the bursting of the 2000 dot.com bubble and the 2006 housing and credit market bubbles should be informing the Fed of how costly burst bubbles can be. When these bubbles burst, they can have major spillover effects on the financial system. They also can have costly effects on output and employment, which make it difficult for the Fed to meet its dual mandate of price stability and full employment.
Another clear sign that the party is in full swing is the very strong economic recovery and the rise in inflation to levels well in excess of the Fed’s target. The economy is now growing at its fastest rate in 40 years, while inflation is running at levels that have not been experienced in 30 years. This unexpected inflationary burst has forced the Fed to almost double its inflation forecast for the year.
While inflation has taken the Fed by surprise and now seems to be rising month after month, the Fed clings to the belief that these inflationary pressures are the result of supply-side problems that will soon be resolved. In particular, the Fed seems to believe that despite the worldwide spread of the Delta variant, global supply chains, particularly those for electronic chips, will soon be repaired. It also expects that the present labor supply shortages that are pushing up wages will be eased once schools reopen and once the generous supplementary unemployment benefits expire in September.
In focusing on supply-side issues and convincing itself that our current inflation problems are but a transitory phenomenon, the Fed seems to be turning a blind eye to the demand side pressures that are building in the economy and that could soon lead to economic overheating.
It is not simply that the Fed is keeping its pedal to the monetary policy metal at a time that the economy is rebounding strongly. Rather, it is that the loosest of monetary policies is being accompanied by the largest peacetime budget stimulus on record. Over the past two years, U.S. public spending has been increased by more than a staggering 25 percent of GDP or by a large multiple of the estimated size of the so-called output gap.
By being slow to wind down its aggressive bond-buying program and repeatedly saying that it is not even thinking about raising interest rates, the Fed is adding fuel to today’s housing and equity market bubbles.
By its policy inaction at a time that real inflationary pressures are building, the Fed also seems to be running the risk that an inflationary psychology could soon take hold, which would complicate inflation’s eradication. The Fed seems to be ignoring Milton Friedman’s teaching that monetary policy operates with long and variable lags. If the Fed waits until inflation accelerates further before tightening monetary policy, it will have waited too long.
One of the disappointing aspects of monetary policy this year has been that it has barely changed even as the economic circumstances have changed dramatically. Despite faster than expected economic growth, a larger than anticipated budget stimulus, developing housing and equity market bubbles, and an unanticipated inflationary burst, the Fed has continued to buy $120 billion a month in U.S. Treasuries and mortgage-backed securities while assuring markets that it will not raise interest rates before 2023.
With every sign that the U.S. economic party risks getting out of hand, let’s hope that at its meeting this week, the Fed starts to remove the punchbowl before it is too late.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.