In the last 6 months the yield on the 10 year note has risen from 70 bps to approximately 150 bps. This move should give us policymakers pause to reflect. For 25 years now, as you all know, we at the Fed, have essentially run an asymmetrical approach to interest rates and in the guidance of policy to the markets. Always lower if we can and very slow to raise and then never back to where we were. We have thus succeeded in bringing down the cost of government and corporate borrowing to very low nominal levels and probably negative in real terms for several years. We can count this as a success. We now however find ourselves at the expected cross roads. We may have gone too far and there are risks in continuing this monetary policy. To quote Keynes, “Once doubt begins, it spreads rapidly”. We need to decide where we go from here; now.
Our policy over 25 years has produced and reinforced moral hazard. Monetary issuance at every sign of asset price decline, GDP shortfall, or one-off supply side benefit, has created an unprecedently large balance sheet for the Federal Reserve Bank system, potential instability in the US $, and therefore possibly an enormous burden on future US tax payers.
The consequences of this enormous balance sheet and monetary issuance can be seen in the elevated price of stocks, bonds, real estate, and more worryingly in the steadily lower quality of capital allocation and business formation. The only way current asset prices can be sustained is through the continued expansion of our balance sheet and this would jeopardise confidence in our fiat money system.
Unlike one of your predecessors, we think we should act when we can clearly see asset price bubbles and that time is now. Low levels of CPI increases are used by Fed spokesmen as justification for continued loose monetary policy, but every large asset price crash producing economic and social turmoil, also occurred against this backdrop of ‘tame’ consumer price inflation. We are frankly ignoring plain warning signs elsewhere.