Bubble or Recession: The Fed Must Choose

Posted July 25, 2017

Janet Yellen and her colleagues are facing a difficult predicament. If the Fed does not tighten monetary policy, then a destabilizing asset price bubble could run out of control and wreck the banking sector again. However, if the Fed does tighten monetary policy, then credit is likely to contract, in which case the economy would enter a severe recession. The latest Macro Watch video considers the Fed’s no-win situation as well as how the Fed’s next moves are likely to impact the financial markets.

The Fed’s plans to launch Quantitative Tightening could suck $1 trillion of liquidity from the economy and the financial markets by the end of 2019. Such a radical removal of Liquidity would very likely cause interest rates to rise sharply, asset prices to crash, credit to contract and the economy to enter a severe recession or worse.

Economic growth and wage growth are weak and Consumer Price Inflation is below the Fed’s 2% target. So, why would the Fed undertake such a dangerous reversal of Monetary Policy now? The explanation must be that the Fed is worried that if it doesn’t act now, the asset price bubble will become so large that it will set off a new systemic crisis in the financial sector when it implodes.

Bubble Zone

Asset prices clearly are very stretched. The Wealth to Income ratio has never been higher. The Shiller CAPE Ratio has only been higher twice: before the great crash of 1929 and before another great crash at the time of the NASDAQ bubble.

But here’s the problem. Asset prices are high, but credit growth is weak. If the Fed tightens monetary policy to rein in asset prices, credit could begin to contract. Since credit growth drives economic growth that would throw the United States and the rest of the world back into severe recession.

So, how will the Fed deal with this dilemma? Is now the time for investors to head for the exits? For my views on these questions, Macro Watch subscribers can log in now and watch Bubble or Recession: The Fed Must Choose. The video is 11 minutes long and contains 20 downloadable charts.

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