Like a tightrope walker, Federal Reserve chairwoman Janet Yellen and her colleagues at the Fed dare not lean too far in one direction of monetary policy or another. On the one side, they know that they have to taper their quantitative easing program and generally rein in the Fed's present, extremely easy monetary posture. As former chairman Ben Bernanke has repeatedly made clear, a failure to do so risks financial bubbles and, worse, a generalized inflation. But on the other side, the still fragile state of global finance and economics creates a vulnerability to even minor policy adjustments. The recent turmoil in emerging markets testifies to this risk. It is surely too early to judge whether either danger will become a reality or, if so, which one, but investors, nonetheless, need to keep a weather eye on both sides of this risk equation.
Ominous Precedents
Recent history speaks loudly to these risks, the second one in particular. The last two collapses in markets and the economy—2000–01 and 2008–09—resulted from Fed tightening that otherwise seemed minor, but nonetheless had an outsized impact on markets and through them on economic activity.
The first of these developed less from active Fed policy than from Fed neglect, but ultimately owed much to this kind of a policy error. The problem began in China. Because this country had set out to promote its exports by keeping down the foreign exchange value of its currency, the yuan, the People's Bank of China had to buy dollars almost continually, which it then invested largely in U.S. government securities. This flood of liquidity into U.S. financial markets helped inflate the dot-com and technology bubble that expanded throughout much of the 1990s. The Fed could have neutralized, that is "sterilized," the effect of these Chinese flows, but for reasons of its own, the Fed chose not to do so. It burst the bubble it had allowed Chinese liquidity to create, on its own. And it did so inadvertently. Worried in 1999 about a modest uptick in inflation, policymakers engineered what must have seemed to the Fed very moderate restraint. Short-term interest rates rose by a mere 80 basis points over the course of that year, not even back to the levels that had prevailed earlier in 1998. But markets, already bloated with excess liquidity, had an outsized reaction. The technology and dot-com collapse of 2000–01 followed.1
The second bubble and bust was even more closely related to Fed policy. Of course, Chinese liquidity continued to flow into the United States during the early years of this century, as it still does. This time, the Fed's easing efforts to promote recovery after the technology/dot-com bust actually added to the flood. The investment focus settled on real estate instead of a particular sector of the stock market, but, as previously, the country was experiencing a liquidity-driven rise in asset prices beyond what any economic fundamentals warranted. When the Fed, mildly worried in 2006 and 2007 over economic overheating and a slight acceleration in the pace of inflation, decided to drain a small measure of liquidity from markets again accustomed to a flood of liquidity, the markets reacted radically, even more violently than in 2000. The resulting economic and financial carnage is familiar to all.2
Risk of a Repeat?
Now, as the Fed continues to taper its quantitative easing, the obvious question to ask is whether there is a risk that this pattern of bubble and burst will repeat. The short answer is, yes, the risk exists. Markets for years now, since 2008 in fact, have seen a flood of Fed-provided liquidity, and asset prices have risen in part because of it. What in any other circumstance would look like the most modest of policy adjustments could create an outsized reaction. But if the risk of a repeat exists, much evidence suggests that it is not a probability.
On the worrisome side is the recent behavior of risk assets, particularly in emerging markets. From the moment last spring that the Fed first began to talk about tapering, emerging market currencies, bonds, and equities have all suffered and in much the same way as when past bubbles have burst. Between June and September last year, emerging market equities, as a group, lost about 13% of their value,3 even as many of their currencies also suffered setbacks and the rates they had to pay to borrow rose. When the Fed forewent a tapering move last September, these equity markets recovered some of the ground they had lost, but they gave it all back and more when the Fed actually began to taper in December 2013 and January 2014. Meanwhile, currency pressure in several of those countries reached crisis levels, and the rates markets charged them to borrow rose still more, whether the debt was denominated in dollars or in their own currencies.
As familiar as the pattern looks on the surface, however, several differences from the past push the probabilities away from a repeat of such disasters. For one, the Fed's actions to date hardly constitute even modest monetary restraint. Policymakers, after all, have only slowed the pace at which they are pouring new liquidity into markets. Up until last December, the Fed was buying $85 billion a month of Treasury and mortgage-backed bonds. The Fed has slowed down the flow to $65 billion a month.4 This is hardly a withdrawal of liquidity. Indeed, it still constitutes a torrent of monetary support. Meanwhile, the Fed has kept short-term interest rates near zero, another major support to the markets. Nor are markets as overpriced as they were in 2000 or 2008. The rallies of the past few years have realized much of the superb valuations that had existed, but in no way are either equity or real estate prices as far from the economic fundamentals as they were in past bubbles.
The Balance of Evidence
To be sure, people in the past seemed unaware of how out of line prices had become, and the Fed thought it was following a moderate path. It also is true that emerging markets concerns today go beyond liquidity. Argentina, for example, suffers from an unsupportable debt overhang and Turkey from political discord troubles. Questions have arisen about the sustainability of China’s growth rate and its debt overhang. But if this emerging market response is not quite yet the proverbial canary in the coal mine alerting to a danger, it is reminiscent of past blunders and it is a cautionary flag that investors need to acknowledge, even if the entire economic picture still says they may never have to heed it.
¹For more detail, see, Milton Ezrati, Thirty Tomorrows (New York: Thomas Dunn Books/St. Martin's Press; forthcoming April 2014), especially chapter 13.
²Ibid.
³Data from Bloomberg.
4Data from the Federal Reserve.
