Yellen Still Mum on Bubbles

I’m not the only one concerned about asset bubbles fueled by the Federal Reserve’s staunch accommodative policies.

The Fed claims it’s not concerned with how the stock market reacts to its forward guidance. But that’s hard to reconcile with its determined approach toward getting across its message that interest rates will remain low for the foreseeable future.

Through much of 2013 the message was the same, but then the focus was on tapering rather than interest rates. And whenever the Fed hinted that it may be time to start scaling back its monthly bond purchases, stock market investors took the news badly, selling off stocks in almost childlike tantrums.

Eventually the Fed started tapering in January and the economy didn’t grind to a halt. The same will happen whenever the Fed gets around to raising interest rates from the near-zero range where they’ve sat for more than five years.

But as if to appease investors angered that the easy-money spigot is no longer flowing quite as freely, central bankers -- newly-installed Fed Chair Janet Yellen most prominently -- have taken pains to reassure markets that the Fed will remain accommodative long after the bond purchase program known as quantitative easing expires, probably later this year.

The danger is that those repeated reassurances will, unintentionally perhaps, encourage the sort of risky behavior among investors that led to past asset bubbles, ie., tech stocks in the late 1990s and housing in the mid-2000s.

Yellen should be commended for making the high cost of unemployment -- especially long-term unemployment -- an almost personal mission. Her speech last month in Chicago highlighting “labor market slack” employed personal flourishes that immediately set her apart from her predecessors Ben Bernanke and Alan Greenspan, both strictly-by-the-numbers guys.

The message being sent is that addressing the stubbornly weak labor market is a higher priority than the risks associated with keeping interest rates at their historically low levels. The thought being that low interest rates spur borrowing by consumers and businesses that will eventually prompt economic growth and lead to hiring.

Yellen seems determined, however, to avoid any discussion on the threat of asset bubbles.

In a more traditional speech delivered last week, her first as Fed chair purely addressing monetary policy, Yellen covered familiar territory: because the unemployment rate has proven misleading as an economic indicator the Fed will be using an array of data to determine future guidance; also, low inflation is an issue to be watched but not of immediate concern.

Nothing new there.

What was conspicuously missing was any mention of the threat that low interest rates can eventually cause asset bubbles.

There have been murmurs for months that stock markets -- the S&P 500 index and the Dow Jones Industrial average -- have soared to their current near-record highs prompted largely by the Fed’s easy-money policies. Some of the frothier sectors -- untested Internet companies and biotechs -- sold off earlier this month, a positive sign that cooler heads are prevailing.

But bubbles tend to act as their own self-fulfilling prophecies -- right up until they burst.

As the bubble fills with air everyone appears to be winning. In the late 1990s, the Internet was going to make everyone’s life easier and companies participating in that “paradigm shift” could only succeed. No one complained or raised questions as stock markets surged and day traders made millions and the retirement accounts of  mom and pop investors ballooned.

Then the bubble burst.

The same dynamic played itself out during the housing boom last decade. No one complained or raised questions as the value of their homes gained 25% in a single year, allowing homeowners to borrow liberally against all that added equity. And Wall Street played right along, pretending all the mortgages generated during the boom were sound.

Both of those bubbles ended badly, the latter touching virtually all aspects of the U.S. economy and nearly taking down the global economy.

Both of Yellen’s predecessors have been faulted for ignoring signs that bubbles were emerging under their watches. It’s easy enough to do given the appearance created by bubbles that the economy is humming along quite nicely.

Still, it’s the Fed’s job to look below the surface and see what the underlying causes are of any strong shift in economic momentum and to spot troubles in advance.

With that in mind, and given recent history, one would think it would be a high priority for the new Fed chair to reassure Americans that the Fed is staying constantly vigilant with regard to new bubbles.