Two Pins Threatening Multiple Asset Bubbles, Part II

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Part One of this article showed how growing wealth inequality might pressure the Fed to taper QE and/or raise interest rates. Given the indirect market liquidity resulting from the Fed’s stimulus, a reduction is likely a headwind for many asset prices.

In this follow up we discuss another proverbial needle looking for asset bubbles; Financial Stability.

Financial “Stability” Blindness

Fed members are not as open about their desire for higher asset prices as general price inflation. Instead, they often cloak support for rising asset prices with the term financial stability. Based on many Fed statements, financial conditions are stable when equity prices are rising and unstable when falling.

The reality is financial stability, as it relates to markets, is based on valuations and liquidity, not the direction of prices. Markets are most stable when their prices fairly reflect fundamental conditions. As they stray from fair value, prices inherently become more unstable.

Today’s extremely high equity valuations and historically tight credit spreads are signs of bubbles. Unfortunately, most often, such periods are followed by market instability. Not only do price corrections roil investors, but they also hamper financial conditions across the economy.

The reason the Fed promotes higher asset prices is the so-called trickle-down effect. Effectively, they believe rising asset prices benefit economic activity and the welfare of the nation’s citizens. As we will discuss, such a policy is flawed. The Fed wants to boost economic growth with rising asset prices. But to do so today, they must ignore asset bubbles that are forming from excessive monetary policy. The cartoon below is a somewhat accurate portrayal of the flaws of trickle-down policies.

Stability, Two Pins Threatening Multiple Asset Bubbles- Part II

On May 5, 2021, Fed President Williams stated:

I don’t see those higher asset valuations, say, in the stock market or the housing market as being a significant risk for financial stability right now,”

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