Even good bubbles can be pricked

Michael Coote

Friday 23rd April 2004

Implicit within the extremely low interest rates that the US Federal Reserve has been running lies a huge risk: the rate at which markets will react by changing asset prices in response to the start of a return to neutral monetary policy.

If markets overreact by drastically marking down asset values, then all the Federal Reserve's good work in attempting to generate US economy recovery goes down the drain. The problem is addressed in illuminating detail by Pimco economist Paul McCulley in his April commentary Doctor, My Eyes (www.pimcofunds.com).

As the world's largest bond fund manager, Pimco has more than mere academic interest in how and when the Federal Reserve finally decides to pull the plug on reflation. The Federal Reserve's interest rate settings directly affect the value of Pimco's colossal note and bond holdings.

Accordingly, second-guessing the Federal Reserve, and even as Mr McCulley does in his article, lecturing it on how to go about its job, comes with the territory.

Mr McCulley accepts the Federal Reserve has deliberately induced a rational asset bubble in the US by driving interest rates down. The theory is that asset price inflation will generate economic growth and reduce unemployment in the short-term.

A rational bubble is one in which investors see that interest rates will remain low for an extensive period, and thus they can quite logically leverage up more than usual the acquisition of higher-risk asset classes such as shares and real estate. Their collective reaction to cheap money pumps up asset prices and at least for a time ensures a capital gain.

Mr McCulley's viewpoint is enlightening. Generally, asset bubbles are deemed to be an evil, not a good, from the economic point of view, albeit that they are highly desirable to speculators.

He is saying there can be good asset bubbles and that the Federal Reserve has achieved one, to its credit.

The difficulty with even good bubbles, however, is that at some point they must be pricked. The Federal Reserve is only too aware of this and has signaled in recent Fedspeak that it is girding its loins to do the deed. Mr McCulley has no quarrel with this but he does fault the Federal Reserve on two points for how it has gone about preparing to slay the reflationary goose that has laid the golden eggs of accelerating economic recovery.

First, he objects to the way in which the Federal Reserve signaled its intentions over past months by suggesting it had a finite calendar period in mind for sustaining low interest rates before reacting to higher economic growth by return to neutral monetary policy.

Instead, he says, it should have connected its intended policy change with emergence, at some unspecified time, of justifying economic conditions.

By suggesting it had a timeframe, he argues, the Federal Reserve has misled investors into thinking they had some fixed period in which to continue speculative activity. If investors expect there is some definite, if unstated, time period over which speculation will continue to be encouraged, they will be incautious about the degree to which they permit prices to become overextended.

More grievously, however, according to Mr McCulley, the Federal Reserve has wrongfooted itself and the markets by failing to state quantitatively what it believes the neutral stance interest rate to be.

By not revealing this rate to the markets, the risk arises that they will not be able to adjust prices accurately when neutrality is restored.

Pessimistic response to the onset of increased Federal Reserve rates will cause asset prices to plummet. There is the danger that investors will panic, especially if highly leveraged, and rush cliffward, like suicidal lemmings, to unwind their exposures to assets that it is already agreed are overpriced.

The critical question the markets need to have answered is by what degree the overpricing has occurred and where the floor is to which prices should be rationally readjusted when the time comes.

Accordingly, Mr McCulley calls on the secretive Federal Reserve to come clean and say what its target interest rate is. Good luck to him for trying to prise open the oracle's clenched lips.

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