Fed policies aren’t to blame for distorted asset prices, financial conditions have fundamentally changed


The US Federal Reserve’s (Fed) low interest rate policy and quantitative easing have distorted financial markets. At least, that appears to be the conventional wisdom on Wall Street, eagerly embraced at the very top of the industry to serve as the basis for investing decisions.

But what if this hypothesis is incorrect? Then, the conventional wisdom becomes pernicious and generates nothing but costly investment mistakes.

This notion is rooted in the idea that higher rates in the past were “normal” while current rates are “unnaturally” low. These abnormally low rates are to blame for what are seen as abnormally higher asset valuations, which is why the Fed is described as distorting financial markets.

This chain of logic, however, falls apart if rates are not unnaturally low. Indeed, it is more likely that the Fed is not driving rates to unnaturally low levels, but is instead following the neutral (or natural) rate of interest down. Under this hypothesis, the impact of rates on asset prices is not a distortion; it is simply a revaluation forced by a fundamental change to financial conditions.

Former Fed chairman Ben Bernanke attempted to put an end to the conventional wisdom in his inaugural blog post:

“If you asked the person in the street, ‘Why are interest rates so low?’, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates.

“But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth — not by the Fed.”

San Francisco Fed president John Williams, a leading researcher on the neutral rate (also known as “r-star”), surveyed recent estimates and found a substantial downward trend: See Figure 1.

The decline in the neutral rate is embedded in the decline in the Fed’s estimates of the terminal federal funds rate, just 3%, down from 3.8% two years ago. And — importantly for investors — those estimates may continue to fall.

Indeed, if the Fed were holding rates unnaturally low for years, as critics have claimed, we would have expected to see a substantial increase of the inflation rate.

Yet, the opposite has been true. Low inflation continues to vex the Fed, suggesting that the central bank does not need to continue raising rates. This puts in doubt a third rate hike for this year and the Fed’s current expectation of three increases for 2018.

Consider this from Fed governor Lael Brainard in July:

“I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in core PCE (personal consumption expenditures) inflation.

“In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance.”

The implication is that the upside for rates in this environment is almost certainly more limited than the Fed’s critics anticipate. And if low rates are supporting higher asset

prices, you should expect asset prices to remain elevated relative to historical norms (barring a recession, of course).

In other words, the most feared impacts of higher rates will not hap- pen because rates are not poised to move much higher. And if they were to rise substantially, the increase would be on the back of an improving economy, which is generally good for asset prices.

Those who continue to cling to the belief that this rate environment is unnatural will likely continue to believe more tightening is in the pipeline than is likely to occur.

And getting the Fed wrong on this point means getting a lot of other investment decisions wrong, too.

Best instead to stop moralising about central bank policy as “distorting” financial markets and accept that financial conditions have fundamentally changed. As my Bloomberg View colleague Ben Carl- son has explained, this time really is different. — Bloomberg