By Nir Kaissar
(Bloomberg Gadfly) --Attention investors: The Federal Reserve needs you.
The Fed is in a pickle. It badly wants to pull back the huge stimulus it put in place in response to the 2008 financial crisis. The fed funds rate has never been this low for this long. The monthly fed funds rate -- an average of daily rates -- was less than 1 percent for 104 consecutive months from October 2008 to May of this year. Before then, it had been that low just seven times since July 1954, the longest period for which rates are available. The fed funds rate averaged 1 percent in June.
The Fed’s balance sheet, too, had never been bigger than $1 trillion before the financial crisis. It’s now $4.5 trillion.
The problem is that the economy isn’t cooperating. For one thing, inflation is running below the Fed’s target. In its June statement, the Federal Open Market Committee acknowledged that “inflation has declined recently” and that it’s “running somewhat below 2 percent.” In its statement on Wednesday, the FOMC sounded more concerned. It reiterated that inflation is declining and that it’s “running below 2 percent.” Only this time, the phrase “somewhat below” disappeared.
A second problem, as my Bloomberg View colleague Mohamed El-Erian pointed out on Tuesday, is that risks to economic growth are growing, in part because fiscal stimulus like tax reform and infrastructure spending seem increasingly elusive.
Ordinarily the Fed would wait for conditions to improve, but it has something else to worry about: high asset prices. Granted, taming asset prices isn’t part of the Fed’s dual mandate of maximizing employment and stabilizing prices. But Minneapolis Fed President Neel Kashkari said in February that the Fed was keeping its “eyes open for asset prices to try to look for signs of bubbles.” And last month, Fed Chair Janet Yellen remarked that asset prices were “somewhat rich if you use some traditional metrics like price earnings ratios.”
It’s not surprising that the Fed is anxious about asset prices. Like everyone else, it remembers what happened during the previous two market cycles and undoubtedly wants to avoid a three-peat -- particularly because the Fed still had tools to support sagging asset prices the last two times.
The fed funds rate, for example, averaged 5.9 percent in March 2000 when the dot-com bubble popped. It averaged 5 percent in August 2007 when cracks first appeared in subprime mortgages. Both times, the Fed lowered the fed funds rate by roughly 5 percentage points to help stabilize asset prices. If asset prices were to tumble now, the Fed wouldn’t have that luxury.
In fact, asset prices have never been this high while the fed funds rate is this low. The cyclically adjusted price-to-earnings, or CAPE, ratio for U.S. stocks, as calculated by Yale professor Robert Shiller, was 30.1 in June. Since July 1954, the CAPE ratio has been 30 or higher during 56 months, and 55 of those came during the dot-com bubble and its aftermath from 1997 to 2002. The average fed funds rate during those months was 5.1 percent. The average fed funds rate in June was just 1 percent.
It’s not just stocks. The dividend yield of the FTSE NAREIT All REIT Index was 4.2 percent in June. Since 1972, monthly yields have been lower than 5 percent 115 times. (Yields and prices move in opposite directions.) Of those, 24 were during the run-up to the financial crisis from 2004 to 2007, when the fed funds rate averaged 4.8 percent. The remaining 91 have been since 2009, when the fed funds rate has averaged just 0.2 percent.
The concern, of course, is that asset prices will tumble and take the economy or inflation down with them. This is where investors come in. Unlike economic growth or inflation, asset prices are ultimately in the hands of investors. I’m not suggesting that investors are going to stop markets from declining. But if they keep their cool, the declines need not be as severe as they were during the dot-com crash and the financial crisis.
I realize this sounds fanciful, but there are good reasons to believe that investors might be better behaved the next time markets wobble. For one thing, not everyone agrees that asset prices are high, or that the CAPE ratio is a reliable gauge of valuations. Those investors would presumably be less likely to sell.
Also, the ranks of passive investors have swelled since the financial crisis. According to Morningstar, the assets managed by passive mutual funds and ETFs grew to $5.4 trillion in 2016 from $1.2 trillion in 2008. If those investors remain faithful to their mantra, the next sell-off should be less severe than previous ones.
So investors, the next time declining markets tempt you to sell your assets, remember to give the Fed a break.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.