Neel Kashkari Argues Against Pricking Financial Bubbles

The Minneapolis Federal Reserve President Neel Kashkari is an outspoken thought leader on the Federal Open Market Committee. When he makes statements, it’s worth noting his points. I say he’s a thought leader, not because his points are correct, but because they can affect policy. I think his latest thesis was completely wrong. To summarize, Neel stated that the Fed shouldn’t use interest rate policy to squash asset bubbles. There are a few points Neel makes which support his thesis. The first point is that it’s difficult to identify bubbles. This isn’t accurate. It’s very easy to identify bubbles. The difficult part for traders and investors is timing when they will burst. When bubbles are growing, skeptics look foolish claiming they will pop, but then they eventually collapse. Many analysts and investors saw the housing bust coming and the technology bust coming.

The reason why Neel says that’s it’s difficult to spot bubbles is because he doesn’t understand what causes bubbles. The biggest cause of bubbles is the federal government. Government guaranteed loans created the student loan bubble and the housing bubble. Low interest rates increase speculation. The Federal Reserve has set the Fed Funds rate below the Taylor Rule and has used quantitative easing to buy longer term bonds to sink rates on long maturity bonds.

It’s impossible to know for sure what the Fed’s QE has done to the bond market. The Fed is taking supply out of the market by buying bonds which should increase prices. However, some say the Fed increasing risk in the system has encouraged a flight to safety trade which involves buying treasuries. Either way, interest rates are lower than they would be if the Fed used a rules based approach to monetary policy. Furthermore, this low interest rate environment has encouraged investors to take more risk to gain a decent return. It’s common sense that if more investors than ever before take more risk, bubbles will be created. When interest rates rise to a more historically normal level, assets like the stock market will crater in value. Unless you think that these historically low rates will stay low indefinitely, it’s clear that there are many asset bubbles in the financial system.

These points which Neel is making are structured as caveats. It’s a reasonable way to pose the question because the Fed deciding to prop bubbles would be a change from historical policy. The Fed raising rates in the early 2000s led to the housing bubble bursting, but that wasn’t the plan. Obviously, the Fed didn’t want to bring the financial system to its knees. The second caveat Neel makes is that he says there is too much risk to making an error. What he means is if the Fed decided to raise rates to prevent a bubble from growing too large and there was no bubble in the first place, then the entire policy was a waste. This mistake could hurt the economy unnecessarily.

The reason this thinking is faulty is because bad policy creates asset bubbles. If there was an example where a bubble was created when the Fed had an optimal policy, then it would make sense not to deviate from the plan. However, this is a false scenario. Evidence that policies which create bubbles are bad for the entire economy can be seen by the current bubble. There is a bubble in auto loans, rent costs, student loans, and the stock market. When this next bubble bursts, which has been dubbed by many to be the ‘everything bubble’, there will be proof that the bubbles didn’t come out randomly. They were created by bad fiscal and monetary policy.

The third and final caveat Neel makes is that he believes the Fed couldn’t slow asset price growth if it tried to. That is incorrect in most cases. All the recent bubbles have been created by the government. If there were a bubble created solely because of speculation, then the Fed shouldn’t actively get involved in the free market, but it’s a silly argument to make because as I said the previous bubbles have been caused by the Fed. Another way to look at this is whether the bubble is systemically significant. The tech bubble wasn’t that bad in terms of economic effects as the recession in the early 2000s following its burst along with the 9-11 terrorist attacks was mild. The housing bubble's bust became systemically significant because the mortgage backed security risk wasn’t understood.

My thesis on monetary policy relies on knowledge gleaned from the current bubble. If my analysis is incorrect and there aren’t problems stemming from the areas I’ve highlighted such as the auto loan market, then my argument loses value. The reason I rely on it so heavily is because the bubble is more pervasive than ever and will be the final nail in the coffin for Neel’s arguments.

Instead of actively trying to prevent asset bubbles from bursting, Neel believes the Fed should uses its supervisory powers to protect the banks from failure. That’s a mistaken argument because he’s only basing his opinion on the last bubble. If the next bubble is in other areas of the economy, helping the banks may not be relevant. One example of a problem unrelated to the banks is the underfunded pension system. In fact, the low interest rates Neel is proposing has created that problem as well. He won’t have an answer on how to solve underfunded pensions after the stocks pension funds invested in lose value.

A cratering pension system would be considered a black swan event by mainstream economists, but I don’t believe in the term. My belief is that there is no such thing as a black swan because these events have all been predictable if you understand the causes of them.

To be clear, Neel’s influence is on how the Fed should act regarding bubbles. His push for less rate hikes as member of the FOMC isn’t gaining steam as the Fed is guiding for 3 rate hikes this year.

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