Using Rate Hikes To Pop Bubbles

Federal Reserve policy makers are embarking on a subtle shift in strategy with potentially big implications for investors: using interest rates as a tool to contain the knock-on effects of lofty stock and asset prices on financial stability and the economy. The sharpened focus on asset values evident in Fed officials’ public and private remarks suggests the central bank will be more inclined to raise interest rates than otherwise, even if inflation is low. It also means that financial markets can no longer expect — in the words of Allianz SE chief economic adviser Mohamed El-Erian — the Fed to be their BFF, or best friend forever, providing them with unstinting support…Led by former chairman Alan Greenspan, central bankers had long argued that they were ill-equipped to spot bubbles in the making and the best approach to tackling them was to let them burst and clean up the mess afterwards. But behind the latest shift is a recognition by officials that the last two recessions were at least partly prompted by declines in markets that had gotten too frothy — technology stock prices in 2001 and housing in 2007. Fed Chair Janet Yellen hinted at the change last week in laying out her argument for further, gradual interest-rate increases. Not only does “persistently easy monetary policy” raise the risk of an overheated economy, it “might also eventually lead to increased leverage and other developments, with adverse implications for financial stability,” she said in a speech in Cleveland.