Whether or not the recent surge in consumer price inflation will be a lasting phenomenon is subject to legitimate debate. However, by now one thing should be clear. Through its truly massive bond-buying program, the Federal Reserve has created and continues to create asset price and credit market bubbles. Based on past experience, this hardly bodes well for the US economy having a soft-landing next year when the music of ultra-easy money eventually stops playing.
Anyone doubting that the U.S. economy is now in the grips of yet another housing market bubble need only take a cursory look at the authoritative Case-Shiller housing price index. Adjusted for inflation, that index is now at approximately at the same level that it reached in 2006 at the peak of the last housing market bubble. Of further concern is the fact that U.S. home prices are continuing to rise at an annual 12 percent rate.
Anyone doubting that we are also experiencing an equity market bubble need only look at today’s extraordinarily stretched equity market valuations. As measured by cyclically-adjusted price-earnings ratios, today’s equity valuations are more than double their long-term average. More striking yet is the fact that these valuations are at lofty levels that have been experienced only once before in the last one hundred years.
The one thing that the U.S. housing and equity-market bubbles have in common is that they have been fueled by an unprecedentedly rapid pace of Fed bond buying aimed at keeping long-term interest rates low to stimulate the economy. Whereas following the 2008 Lehman bankruptcy it took Ben Bernanke’s Fed six years to increase the size of the Fed’s balance sheet by around $ 4 trillion, in the wake of the Covid-19 pandemic it has taken the Powell Fed barely six months to do the same thing.
Over the past few decades, a persistent weakness of the Fed has been its seeming lack of attention to the asset price bubbles that it creates until those bubbles happen to burst. The Powell Fed would seem to be no exception. Even at a time that the Fed’s own Financial Stability Report acknowledges that there is considerable froth in the housing and equity markets, the Fed is only now starting to think about tapering its bond-buying program. Meanwhile, it continues to add froth to those markets by buying $80 billion a month in U.S. Treasury bonds and $40 billion a month in mortgage backed securities.
To be sure, the U.S. banking system is in a very much better position to weather a housing market today bust than it was in 2008. Lending standards in the housing market today are very much better than they were back then. In addition, today’s banks are very much better capitalized now than they were before.
However, unlike in 2008, the problem for the U.S. financial system this time around is that the prospective housing market bust would not be occurring in isolation. Rather, any housing market bust triggered by higher interest rates would all too likely be accompanied by the bursting of the many other asset and credit market bubbles around the globe that have been spawned by the money printing of the world's major central banks. These include the U.S. and global equity bubbles, the bubbles in the U.S. and European high-yield credit markets, and the emerging market debt bubble.
All of this makes it difficult to understand the Fed’s thinking as it clings to its ultra-easy monetary policy at a time that the economy is recovering strongly and asset and credit market bubbles are in plain sight. By keeping its pedal to the monetary policy metal at the same time that the country is engaged in its largest peacetime budget stimulus on record risks overheating the economy and being forced to slam on the monetary policy brakes. Meanwhile, by continuing its large-scale bond-buying operation, it adds fuel to the asset price bubbles making it all the more difficult for the Fed to engineer a soft economic landing.
One has to hope that the Fed soon realizes the dangerous path on which its currently ultra-loose monetary policy is placing the U.S. economy. At a minimum, one has to hope that the Fed soon stops buying mortgage-backed securities in the midst of a housing market bubble. However, judging by Fed Chair Jerome Powell’s most recent pronouncements on this matter, I would not suggest holding one’s breath for this to happen.
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.