Market volatility has the Fed facing a dilemma of its own making

The economy has become heavily dependent on financial asset prices. Thus, the recent volatility in the stock and bond markets bear close watching.

These price swings are likely to persist, especially if the Federal Reserve makes a policy mistake. This probability is rising, as Fed members are effectively trying to engineer a soft landing, i.e., a cyclical downturn that avoids a recession, in both the financial markets and the real economy. This is something that has never happened before.

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At present, the level of total financial assets as a share of GDP is at a record high. This is troubling and no doubt related in large part to extraordinary monetary policy actions taken during and after the financial crisis.

The Fed implemented zero interest rates, quantitative easing and forward guidance to stimulate the economy. Surging financial asset values were part of the calculus.

In turn, the ratio of financial assets to GDP stood at 4.35 in the third quarter (3Q) of 2018, the last quarter for which official data are available. This was up from 4.31 in Q2 2018 and is up markedly from the last business cycle’s peak of 3.80 in Q3 2007.

A chart from 2002 to 2018 shows exponential growth in this ratio. However, the series looks like it has reached its apex.

According to our calculations, the ratio of financial assets to GDP fell last quarter to 4.29. This would be the first decline since Q2 2016 and the largest decline since Q3 2015. The Fed releases the official Q4 2018 data on March 7. 

With the Fed on path to raise rates further this year (and next) and with the balance sheet on track to shrink by approximately $600 billion in 2019 alone, the value of financial assets is likely to decline further. Monetary policy was much looser in 2015 and 2016, which allowed financial markets to recover.

Importantly, the ratio of financial assets to GDP peaked before the onset of each of the last two recessions. Hence, we wonder whether we are on the cusp of another such decline, with obvious negative economic implications to follow. Why is the Fed not more concerned?

Outside of autos and housing, the economic fundamentals still look good: The unemployment rate is at a five-decade low and real GDP appears to be relatively robust. However, too much of past Fed behavior was geared toward stimulating financial markets.

Given their massive size, the Fed faces a dilemma albeit of its own making. Tighten too much and the economy will rollover. Tighten too little and the financial asset share of GDP potentially scales new heights. The central issue then becomes, how best to proceed?

Let the economy run hot, and keep interest rates low in order to stimulate a sustained cyclical lift in inflation. While financial markets could then potentially reheat, a Fed engineered recession would be even worse. Monetary policymaking needs a do-over and soon. We hope the central bank is listening.

Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France with 31.2 million clients spread over two retail banking networks, Banque Populaire and Caisse d’Epargne.