Dallas Fed President Robert Kaplan just went full 1996 Greenspan…
In an esay designed to explain “A Balanced Approach to Monetary Policy”, Kaplan included an ominous section pointing at the very significant bubbles that have been blow in recent years…
As a central banker, I want to be vigilant to imbalances and distortions that can build as a result of accommodative monetary policy. I have argued that monetary policy accommodation is not “free” —there are costs to accommodation in the form of distortions and imbalances in consumer decisions as well as in investing, hiring and other business decisions. More specifically, experience suggests that the greater the overshoot of full employment, the more difficult it is to unwind imbalances when growth ultimately slows—as it certainly must.
When excesses ultimately need to be unwound, this can result in a sudden downward shift in demand for investment and consumer-related durable goods.
There are surprisingly few historical examples of “soft landings” in cases where employment has risen above its maximum sustainable level.
It is of course possible that “this time will be different,” but as I assess the condition of the U.S. economy, I am carefully monitoring evidence that might suggest growing risks of real imbalances, which could threaten the sustainability of the current economic expansion. For example, the headline unemployment rate has fallen by 70 basis points over the past year, nearly matching the average rate of decline over the prior seven years of the expansion. If this rate of decline continues, this will further tighten labor market conditions and would likely add to excesses and imbalances accumulating in the economy.
Excesses can also manifest themselves in financial imbalances. While I would prefer to rely primarily on macroprudential policy tools to manage financial imbalances, I am nevertheless monitoring various measures of potential financial excess.
I monitor these and other market measures because I am aware that, as excesses build, we are more vulnerable to reversals which have the potential to cause a rapid tightening in financial conditions, which in turn, can lead to a slowing in economic activity. Examples of potential excesses might include:
The U.S. stock market capitalization now stands at approximately 135 percent of GDP, the highest since 1999/2000.
Correspondingly, commercial real estate cap rates and valuation measures of debt and other markets appear notably extended.
Measures of stock market volatility are historically low. We have now gone 12 months without a 3 percent correction in the U.S. market. This is extraordinarily unusual.
While household debt to GDP has improved over the past eight years, corporate debt is now at record highs. I am not overly concerned about current levels of corporate debt because, importantly, financial sector leverage has declined substantially since the Great Recession. However, U.S. government debt now stands at approximately 75 percent of GDP, and the present value of unfunded entitlements now stands at approximately $49 trillion.
In my view, the projected path of U.S. government debt to GDP is unlikely to be sustainable – and has been made to appear more manageable due to today’s historically low interest rates.
Debt and equity securities trading volumes have markedly declined over the past several years. For example, NYSE equity trading volume on average for 2017 is down 51 percent from 2007 levels, while the NYSE market cap has increased 28 percent over the same time period. I would also note that margin debt is now at record-high levels. In the event of a sell-off, high levels of margin debt can encourage additional selling, which could, in turn, lead to a more rapid tightening of financial conditions. Sufficient market trading liquidity is key to managing the resulting increased volume. I am cognizant that lower trading volumes may be due, in part, to low levels of market volatility and may also be due to regulations such as the Volcker rule.
In the context of managing potential financial imbalances, I believe that we have been well served by strong macroprudential bank regulatory policies which have created tough capital requirements and regular stress testing for large systemically important institutions. These measures have helped guard against excessive debt buildup and creation of other imbalances which often accompany elevated levels of asset valuation.
I strongly favor a prudent review of Dodd–Frank and the Volcker rule, as well as regulatory relief for small- and mid-sized banks. However, I also believe that maintaining strong macroprudential policies for big banks—particularly stringent capital requirements and rigorous annual stress testing—is very important for managing potential financial imbalances at this stage in the economic cycle.
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Of course if this is Kaplan’s “irrantional exuberance” moment, then he will be wrong before he is right…
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