There are asset bubbles in every corner of the financial markets. While some of these may not be big bubbles, it is hard to argue that asset prices are not broadly inflated, and intentionally so. Bond yields are well below levels an investor would expect, given the macro growth forecast. Total stock-market capitalization is at its highest ratio to overall GDP since the tech bubble. Stock price-to-earnings multiples are inconsistent with a 2-percent economy, although they are justified by extraordinarily low interest rates. In each case, asset prices are being intentionally inflated from their fundamental valuations. The longer rates stay at zero, the more dislocated capital flows will be and the more problematic these bubbles may become. Most concerning, no one can predict how this will end.
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Inflated asset prices are not having the broad impact on consumer behavior that would be expected. While it is true that rising asset prices have grown household net worth, the subsequent "wealth effect" has not occurred broadly because the gains have been largely skewed to higher income households. Of the $26 trillion of growth in household net worth since the nadir of the cycle, $21.5 trillion of that has come by way of financial asset growth (assets which are primarily held by wealthier households) and just $4.7 trillion has come from real estate asset growth (assets which tend to be the nest egg for lower- to moderate-income households). As a result, the bottom 50 percent of households by net worth have realized just 3.3 percent of the total gains in household net worth. This is precisely why wealthier households have fared quite well over the past five years, and why a broader based wealth-effect has not occurred.
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The Fed's zero-rate policy is keeping real interest rates negative—a double-edged sword for income growth, hurting both interest income and wage growth. The first and most direct effect of negative interest rates is that interest income, one component of personal income growth, has been in a state of decline since 2007. As a result, seniors are forced to stay in the labor force longer, evidenced in the labor force participation rates. This phenomenon has brought about a second, equally damaging result to income growth. As seniors stay in their jobs longer, advancement opportunities for younger people and entrance into the labor force are proving to be more difficult. Without opportunities for advancement, younger workers' wages are stagnating.
When the next economic downturn arises, the Fed has no powder. Monetary easing can be compared to having a sale at a retailer. History shows that discounting the cost of money has an immediate impact on investment and consumer behavior, just like a big sale has. However, that effect lessens over time in both cases. Retailers who recognize this keep some scarcity to their discounting by limiting the number of sales they have each year. The Fed has effectively been having a sale for 67 months; and, as any consumer knows, a 67-month-long sale loses its impact. As a result, their zero-rate policy has lost much of its utility. From the macro prudential perspective, the Fed needs to have tools available when the next downturn comes, and it will come.
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Inflation is now at the Fed's 2.0-percent target and the labor market is much tighter. While some Fed officials still see excess slack in the labor market, the short-term unemployment rate has dropped to 4.1 percent — a frothy level historically. Job openings are at their highest level since 2001. Initial jobless claims and layoffs are at historically low levels. And employers are increasingly saying that it is difficult to find qualified employees to fill their job openings. These are all factors which can make for wage inflation. If wages begin to grow at a faster pace, the Fed risks getting behind the curve — a place it does not want to be, given how complicated tightening policy may be with such a large balance sheet. If wages do not begin to grow, there is a structural problem within the labor market that monetary policy is not affecting. Either way, the labor market does not need to be on life support any longer.
Given the risks associated with a zero-interest rate policy, the future uncertainty of what those risks really mean, and the limited visible benefits; the Fed needs to begin raising their overnight target rate sooner than later. What better time to do it than when the European Central Bank is taking the torch of accommodation.