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September 07, 2017 at 12:28 PM
The Federal Reserve’s 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.
(Related: 5 Things Pru’s Investment Chief Told the Bankers)
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, as the figure above shows. 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.
(Image: Thinkstock)
